In early 2015, I began the process of reviewing my investment strategy and concluded that I would make a shift away from individual shares and some managed investment trusts in favour of more index funds. I was particularly drawn to the simplicity and balance of the Vanguard LifeStrategy option. This one-stop solution formed the central theme to my latest book ‘DIY Simple Investing’.
My Vanguard FTSE Equity Income pays a reasonable income however I do not want too much exposure to the UK equity market, therefore an increasing proportion of my portfolio has been reinvested in the VLS funds which are globally diversified.
However, whereas the yield on my UK Equity Income fund is around 4.5%, the natural yield on the VLS fund is currently only around 1.3%. The plan was therefore to sell off some units from the accumulation version of my fund to provide ‘income’.
It would not be viable to sell units on a monthly or quarterly basis due to the dealing costs involved - currently £12.50 per sale transaction with my Halifax Share Deal ISA. I therefore plan to sell down capital units from VLS just once per year.
There is also the question of what to do about the years when there is little or no capital growth to cover the 4% sell down or even years when there is a reduction in the capital value.
The Plan for Selling Capital
The LifeStrategy funds have been going for just over 5 years. The average total return for the VLS 60 fund since launch has been 8.2% p.a. so at first glance you would think it would not be a problem to sell down 4% of units each year to use as income.
However, whilst the past 5 years have been reasonably positive for both equities and bonds, I am expecting the longer term average to come down to nearer 6% p.a.
Also the 8% is averaged out over the five years. Looking at each year separately, the rolling 12m returns have been:
To June 2012 3.36%
To June 2013 12.05%
To June 2014 7.98%
To June 2015 7.28%, and
To June 2016 10.55%
Total return for the current year-to-date is 12% - much of this is due to a recent surge and the result of the falling value of sterling post the Brexit result.
I have been viewing Vanguards simulated asset class risk tool for the 31 yr period 1984 to 2015 and using a 60/40 equity/bond allocation. Over this longer period the average return has been 9.5%. There have been just 5 years when returns were negative and 26 yrs when returns have been positive.
The plan will therefore need to be flexible enough to avoid needing to sell capital when total return for the year is flat or negative.
I have therefore put in place a cash buffer - an instant access building society account - which holds the income I would require for at least three years - so a minimum of 10% of the VLS fund value. This should provide a sufficient buffer and enable me to draw 3.5% income for 3 yrs without selling any units in my index fund.
During the positive years I will rebuild any shortfall in the buffer account to bring it back to the 10% min. and when this is restored I will simply sell 4% of the value of my VLS fund for income. Obviously, should there be a run of consecutive returns above say 5%, I will have the option to build up the buffer account to a higher percentage, take more ‘income’ or leave the excess returns invested within the VLS fund.
My First Full Year
Fortunately, the returns from my VLS fund has been positive. Last month the return was just 4% but after the recent fall in sterling - currently $1.30, the value of the fund has increased by 15% over the past year.
Of course, this inflated value will fall back should the GBP rally against the US dollar. In view of the unexpected windfall, I have this week sold 8% of my units - sufficient for 2 years income. The additional 4% will be added to my cash buffer which now stands at 14.15% including the accumulated interest over the past 12 months.
The VLS 60 fund currently stands at an all time high of £155. Back as recently as February, the fund was in negative territory at just £131 and at this point I was thinking I would need to use my cash buffer in my first year. Just goes to show how fickle the markets can be and how quickly and dramatically things can turn from negative to positive - just like life I guess!
For most of my investing career I have taken the natural yield from my shares and investment trusts - and for income seekers this can be a very good strategy. However it can create blindspots as you tend to filter options according to yield which obviously would rule out the likes of Vanguard Lifestrategy funds and many other perfectly sound investment opportunities.
I imagine most investors would make use of the LifeStrategy funds during the build stage of their investing career - usually via monthly DD on auto with their broker but I hope this will demonstrate it can also be an option during later years when the emphasis may shift towards preservation of capital and generating income.
So far,so good.
It's always a difficult balance when entering a drawdown phase. I'm not sure there is an easy answer, we all have our favoured approaches, but the one thing we all hate to see is our capital diminishing unless of course we have set a target to deplete the capital, which is not a plan that I favour myself. As to holding a cash buffer, this is my favoured approach, trying to seek out those accounts that will pay me 5% without locking me in but they are not that easy to manage with the funds necessary to support 2 years of cash buffer, so end up with 1.25% for the rest.
I still avoid all bonds as they must eventually fall dramatically in capital value and prefer to stick to Equities, but I will probably always be an Equities man and not a Bond man, but each to their own.
For me the Yield plus some capital growth is my favoured approach and I'm still at the stage where I can and want to actively manage my investments. Just sold out on some of my Non-UK investments to lock in the currency gain, especially as I think the depreciation on the currency is overdone, but who knows, we are into unchartered territory on so many frontiers.
Interesting to learn how others approach this. I agree on preference to maintain capital value. Was it Buffett who had the 2 rules - 1. Never lose money, and 2. Never forget rule 1.
I am sure I would not like the volatility of 100% equities in retirement - you must have a strong constitution! I hope you are wrong on bond values falling - it has been predicted for many years but so far...as you say, each to their preferred allocations.
Its likely to be an interesting journey for the coming year or so..Brexit to negotiate, US elections (Trump or Clinton), US markets at an all time high point...
How do you decide how much to sell and when? If there's been a run of a few good years then you sell 4-and-a-bit percent and in the not-so-good years sell a bit less than 4 percent?ReplyDelete
If the size of the buffer is "a minimum of 10% of the VLS fund value," then why would you need to "rebuild any shortfall in the buffer account to bring it back to the 10% min" in positive years? Do you consider 10% a kind of soft rather than a hard minimum?
I'm still well inside the accumulation stage but find decumulation strategies interesting to consider. In the accumulation phase I can follow strictly mechanical rules around when and how to re-balance or transitioning to holding a higher ratio of bonds to shares as I near retirement. Would you say the rules you plan to follow in decumulation are less rigid and more about gut feel?
This bogleheads page lists a few different strategies:
Their Variable Percentage Withdrawal method seems appealing but I wonder if it will be too complex for me to get my head around in my latter years. I guess if that becomes a problem then there's always annuities.
Thanks for outlining your strategy and your continued thoughts.
You pose some interesting questions and I will clearly need to give a little more thought to how I draw down the income from capital. I guess I will be learning as I go along.
Thanks for the link. I suppose the easiest approach is to draw say 4% in year 1, then assuming the portfolio has increased, withdraw the same amount + inflation in year 2.
Therefore I think the constant dollar/pound example would be the nearest match but then I have the cash buffer to fall back on during years when there is little or no portfolio growth.
From a practical point of view, it's not so crucial as the 'income' from my VLS fund contributes less than 20% of the total and also my state pension will start in a couple of years and therefore the income from my investments will be more for discretionary spending rather than essentials.
The more you think about these issues the more complicated it can become however I will give a little more thought to this and post a follow-up article in due course.