My recent FT Money article
Given the glowing reviews of my article last year for the (London) Financial Times, I was invited to send them some thoughts on how pension savers should react to the current bleak market conditions. I assembled some brief thoughts, which I considered neither inspired nor particularly original. But the editor judged them a breath of fresh air, adding: “It’s your usual mix of very sound, clearly expressed advice on some thorny pensions issues. You always frame things so well. Our readers will appreciate it.” A lightly edited version of what I sent him appeared in print in the FT Money supplement on Saturday July 9, and a few days earlier online.
I’m glad to say that the online comments are positive. “Simple, useful advice in plain language. Thank you.” And: “This is very good advice, simple and clear… Don’s books are a good source for planning, and William Bernstein’s four books “The ages of the investor” through “Rational expectations” are well worth reading if you are running your own portfolio.” I’m a huge admirer of Bernstein, so it’s a particularly appreciated compliment to be mentioned alongside him.
Here’s the text.
Financial market conditions appear bleak. Inflation has driven interest rates higher, leading to falling prices in the equity and bond markets. The contrast with a prolonged period of rising prices in both markets is huge.
It’s natural for retirement savers to feel depressed, not just about the present but also about future prospects. And it’s particularly gloomy because the ballast traditionally provided by bonds when equities fall can no longer be taken for granted.
So the big question is: what can you do? I’ll focus on three aspects. What can savers do? What can retirees do? And what can you do to prepare for the inevitable next visitation of adverse conditions?
The first question is the most comforting to answer. Savers should recognise that their assets no longer conform to their planned allocation (whatever it might be). So the first thing is to rebalance back to it. This has the fortunate effect of buying into whatever has fallen furthest, taking advantage of the new lower prices.
In fact falling markets are, perhaps paradoxically, good for savers. Think of the falling prices as a sale. The amounts you had planned to invest regularly will now buy more units of each asset class than they would at the previous higher prices.
Of course that advantage only holds if falls are temporary. But they usually are. That’s the good news. There’s always the possibility that markets never recover. That’s what author William Bernstein calls “deep risk” – and frankly there’s no satisfactory way to deal with that. It’s little comfort that the whole world will be seriously affected, not just you – but that’s the reality of it.
So let’s assume that the falls are not so much long-term as short-term or medium-term. And short-term falls are not a problem if you don’t panic and sell. The only defence against panic is to think rationally rather than emotionally.
The savers most affected by a medium-term fall are those who are relatively close to having to start cashing out gradually as they approach retirement. And the same problem is even worse for those who are already in retirement and see their pension pot fall in value. So let’s focus on them, and get to the second question I mentioned earlier.
Retirees are particularly vulnerable to what is termed, in the jargon, “sequence of returns risk.” They don’t have the luxury of waiting to allow future high returns make up for current negative returns, because their assets are declining as they make withdrawals to sustain their spending needs, and those future high returns act on a smaller asset base. So a sequence of returns that starts low or negative can’t be balanced by later high returns.
That means it’s essential to have a part of your pension pot that’s relatively immune to falling asset prices. And the only such assets are cash-like assets, or at any rate short-term assets, which decline little as interest rates rise.
I think of this as a “safety pot,” in contrast to the rest of the pot, which is your “growth-seeking pot.” Of course there’s a further problem right now, in that stable-value assets are no protection against high inflation.
The only protection lies in assets with returns that are themselves linked to inflation. Americans are lucky in that the US government issues what are called I-Class Savings Bonds (I-bonds for short) with returns that are constantly adjusted to match inflation.
The closest available in the UK are index-linked gilts, for which the interest and maturity payments are adjusted to reflect inflation. But reflecting inflation doesn’t mean matching inflation. In fact for some years the yields on these gilts effectively reflect negative inflation, and it’s not much comfort to get payments that go up and down with inflation, but at a level constantly below inflation. Nevertheless, that’s life. To the extent that you seek safety against inflation, that safety comes at a price.
It’s these safety-oriented assets – or, if you don’t hold any, the shortest-term bonds in your portfolio – that offer you the least costly defence against sequence of returns risk.
This leads to the final question. What lessons can you learn for next time?
The answer for those of you who are more than, say, five years from having to withdraw money from your pot is nothing, other than that it’s wise to have a long-term investment plan which you can stick to, such as the now traditional “glide path” that underlies many accumulation plans for retirement.
Why five years? There’s no magic to the number. It’s the period of time when historically markets tend to recover to their inflation-adjusted levels after a fall. And yes, history is not a prediction of the future, but it’s at least a guide.
The answer for retirees and those closest to retirement? Build up that safety pot to allow you to gradually withdraw up to five years of spending without touching your growth-oriented pot, if the market takes time to recover from a fall. (I wrote about this strategy in a piece for FT Money a year ago.) And the ultimate defence: be willing to adjust your spending too. Life constantly changes. If we can adjust without too much pain, that’s a big defence against panicky reactions.
There are ways to manage inflation and recession, but safety comes at a price.
I have written about retirement planning before and some of that material also relates to topics or issues that are being discussed here. Where relevant I draw on material from three sources: The Retirement Plan Solution (co-authored with Bob Collie and Matt Smith, published by John Wiley & Sons, Inc., 2009), my foreword to Someday Rich (by Timothy Noonan and Matt Smith, also published by Wiley, 2012), and my occasional column The Art of Investment in the FT Money supplement of The Financial Times, published in the UK. I am grateful to the other authors and to The Financial Times for permission to use the material here.
Many thanks for this article and it was also good to reread last year’s article
I’m 7 years away from retirement and live in the UK. Your suggestion of building up a 5 year safety pot makes a lot of sense. I have three questions
1 When I first came across this concept of a safety pot I had imagined it would simply be in cash, but your suggestion to look at index linked gilts makes a lot of sense to protect onself against inflation. I’m not at all knowledgeable about bonds and if you were able to signpost me to any good resources/sites so that I could learn more about index linked gilts and how they perform and what the levels of risk are I would be grateful
2 I’m working on taking 4% of my pot each year as income. So if my safety pot represented 5 years income, that would mean that the safety pot should be 20% of of my portfolio. Suppose that in the first two years of retirement the market drops and I take my income from the safety pot. That would mean that after two years, the value of the safety pot had dropped to to below 20% – perhaps to 12% say. If in year 3 the market is back up and I start taking my income from the growth pot, would I then seek to rebalance so that my safety pot was back up to 20% or would I leave it at a lower level?
3 In last year’s article, when under the assumptions you set out, you suggested that you could take £5,080 pa from a £100,000 pot, did that assume that the the value of the pot would eventually drop to 0? Or was the assumption that the pot would maintain its value in real terms?
With many thanks, all the best Roger
I’m glad you find these articles useful. Now, specific answers to your questions:
(1) I’d google “index linked gilts” and read whatever comes up. Given that the safety pot is intended to have a 5-year horizon, my personal inclination would be to search for accessibility to index linked gilts under 5 years. Anything longer may well have a lot of volatility, making them risky rather than relatively safe.
(2) My own inclination is: that depends! If the market’s rise is enough to compensate for previous losses, my personal inclination is to rebalance more than one year’s worth. See Post #151 for details on my personal decumulation approach.
(3) Yes, the idea is that the 5,080 implicitly includes a gradual withdrawal of capital, intended to eventually get the pot to zero at the end of the planning horizon. Again, see Post #151 for the potential need to gradually lengthen the planning horizon as your survival lifts you into a longer-lived group.
Hope these brief notes answer your questions. If they don’t, send me a personal email and I’ll write at greater length.