How to calculate the worth of a fixed income product?

Linton

Deleted_User said:

Linton said:

Deleted_User said:

MK62 said:

DT2001 said:

60/40 was just an example. It should be “whatever is appropriate” for you.  My point is that DB income is a type of FI and should be counted as such towards your desired allocation. Ignoring it introduces massive distortions. 

I dont say ignore guaranteed income when designing your retirement portfolio, quite the reverse.  It's just that you dont need to convert it via a dodgy calculation into a hypothetical bond in order to do this.  

As Linton points out if the amount required was low then a perceived lower risk (higher bond allocation) strategy could be used without any distortion when interest rates changed. BUT if you only needed a say 1 or 2% withdrawal rate a 100% equity portfolio would (on historical data) be risk free. 

......but on the same basis, so would a 60/40 portfolio...or an 80/20...or a 30/70....all would have met your income objective!

Let’s say you bought an annuity with half of your money.  Does it mean that the invested portion of your portfolio needs to be split between FI and Equity in the same proportion as before the purchase?

It certainly doesnt follow that if you were previously 50% equity, 50% bonds you should switch to 100% equity since the bond tranche is now occupied by your annuity.

So you are considering annuity as part of your FI. How is DB income different?  

And if the bond tranche is occupied by annuity, why not switch to 100% equity for the rest? I am confused. 

Err, no.  You are wanting to consider guaranteed income such as the DB pension and thus presumably the annuity as part of your FI portfolio.  If you do that then surely my logic applies that since your annuity gives you 50% of "FI" you should have the rest as equity.  Having 0% real FI in a portfolio with a requirement to drawdown whatever expenditure is not covered by the DB pensions and the annuity seems too risky for me.

I take the opposite view.  Neither the annuity not the DB pension have anything to do with FI in a portfolio.  You need to base your allocations on the amount of drawdown income you need to extract from your actual nvestment portfolio.

[Deleted User]

Linton said:

Deleted_User said:

Linton said:

Deleted_User said:

MK62 said:

DT2001 said:

60/40 was just an example. It should be “whatever is appropriate” for you.  My point is that DB income is a type of FI and should be counted as such towards your desired allocation. Ignoring it introduces massive distortions. 

I dont say ignore guaranteed income when designing your retirement portfolio, quite the reverse.  It's just that you dont need to convert it via a dodgy calculation into a hypothetical bond in order to do this.  

As Linton points out if the amount required was low then a perceived lower risk (higher bond allocation) strategy could be used without any distortion when interest rates changed. BUT if you only needed a say 1 or 2% withdrawal rate a 100% equity portfolio would (on historical data) be risk free. 

......but on the same basis, so would a 60/40 portfolio...or an 80/20...or a 30/70....all would have met your income objective!

Let’s say you bought an annuity with half of your money.  Does it mean that the invested portion of your portfolio needs to be split between FI and Equity in the same proportion as before the purchase?

It certainly doesnt follow that if you were previously 50% equity, 50% bonds you should switch to 100% equity since the bond tranche is now occupied by your annuity.

So you are considering annuity as part of your FI. How is DB income different?  

And if the bond tranche is occupied by annuity, why not switch to 100% equity for the rest? I am confused. 

Err, no.  You are wanting to consider guaranteed income such as the DB pension and thus presumably the annuity as part of your FI portfolio.  If you do that then surely my logic applies that since your annuity gives you 50% of "FI" you should have the rest as equity.  Having 0% real FI in a portfolio with a requirement to drawdown whatever expenditure is not covered by the DB pensions and the annuity seems too risky for me.

I take the opposite view.  Neither the annuity not the DB pension have anything to do with FI in a portfolio.  You need to base your allocations on the amount of drawdown income you need to extract from your actual nvestment portfolio.

Granted, you need a cash buffer for short term needs on top of your annuity (assuming it does not cover all your needs). 

But keeping unnecessarily large amount in FI is risky.  If a retiree with most of his income in DB pension were to put most of his pot into bonds or cash, that pot has a very high probability of losing him a lot of money in real terms in 20 years’ time. He is destroying value.  

The reason you would buy an annuity is that it would give you a lot more flexibility to manage short term fluctuations associated with the equities.  Your equities won’t be down in real terms 20 years’ on.  

Compartmentalizing your assets and treating them independently can lead to poor asset allocation.  

MK62

Deleted_User said:

MK62 said:

Deleted_User said:

MK62 said:

DT2001 said:

60/40 was just an example. It should be “whatever is appropriate” for you.  My point is that DB income is a type of FI and should be counted as such towards your desired allocation. Ignoring it introduces massive distortions. 

I dont say ignore guaranteed income when designing your retirement portfolio, quite the reverse.  It's just that you dont need to convert it via a dodgy calculation into a hypothetical bond in order to do this.  

As Linton points out if the amount required was low then a perceived lower risk (higher bond allocation) strategy could be used without any distortion when interest rates changed. BUT if you only needed a say 1 or 2% withdrawal rate a 100% equity portfolio would (on historical data) be risk free. 

......but on the same basis, so would a 60/40 portfolio...or an 80/20...or a 30/70....all would have met your income objective!

Let’s say you bought an annuity with half of your money.  Does it mean that the invested portion of your portfolio needs to be split between FI and Equity in the same proportion as before the purchase?

No, and nobody has said that.......but neither would this then automatically dictate 100% equity either.

You may be likely to have a higher equity content than before though, granted........

You could reverse that though and ask if someone is meeting their income objectives with a 60/40 portfolio, should they move to 100% equities purely on the basis it might give them a higher value portfolio to pass on?

That’s a separate issue.  There are long and short term risks. If you can handle short term risks (eg because you have a salary and are far from retirement) then equities are a better vehicle because bonds are riskier in the long term. 
But you don’t have 100% equity if most of your income needs come from DB sources.  

....but if you have a salary and are far from retirement, you probably won't be drawing down income anyway, and won't be buying an annuity with half your pot either.

I don't think anyone is saying that if you are still in the accumulation phase of your investment journey, and many years from drawdown, you'd construct your portfolio in the exact same manner as you would once retired and into drawdown.........in the former case, equity downturns aren't such a big deal, and are often actually more of an opportunity (as you buy more units with your contributions)......but in the latter case, equity downturns, especially big ones, are far more of an issue.

In the former case, the priority might be maximising returns, while in the latter, the priority might change to minimising risk (and there are, of course, many shades between the two).

DairyQueen

Linton said:

Deleted_User said:

Linton said:

Deleted_User said:

MK62 said:

DT2001 said:

60/40 was just an example. It should be “whatever is appropriate” for you.  My point is that DB income is a type of FI and should be counted as such towards your desired allocation. Ignoring it introduces massive distortions. 

I dont say ignore guaranteed income when designing your retirement portfolio, quite the reverse.  It's just that you dont need to convert it via a dodgy calculation into a hypothetical bond in order to do this.  

As Linton points out if the amount required was low then a perceived lower risk (higher bond allocation) strategy could be used without any distortion when interest rates changed. BUT if you only needed a say 1 or 2% withdrawal rate a 100% equity portfolio would (on historical data) be risk free. 

......but on the same basis, so would a 60/40 portfolio...or an 80/20...or a 30/70....all would have met your income objective!

Let’s say you bought an annuity with half of your money.  Does it mean that the invested portion of your portfolio needs to be split between FI and Equity in the same proportion as before the purchase?

It certainly doesnt follow that if you were previously 50% equity, 50% bonds you should switch to 100% equity since the bond tranche is now occupied by your annuity.

So you are considering annuity as part of your FI. How is DB income different?  

And if the bond tranche is occupied by annuity, why not switch to 100% equity for the rest? I am confused. 

Err, no.  You are wanting to consider guaranteed income such as the DB pension and thus presumably the annuity as part of your FI portfolio.  If you do that then surely my logic applies that since your annuity gives you 50% of "FI" you should have the rest as equity.  Having 0% real FI in a portfolio with a requirement to drawdown whatever expenditure is not covered by the DB pensions and the annuity seems too risky for me.

I take the opposite view.  Neither the annuity not the DB pension have anything to do with FI in a portfolio.  You need to base your allocations on the amount of drawdown income you need to extract from your actual nvestment portfolio.

Agree with Linton and others upthread. The percentage of non-equities in a portfolio should be a product of the individual's drawdown plan (schedule and values). Including guaranteed income within the FI allocation could result in a too-high equity allocation. This could mean, at best, suspension of drawdown at an inconvenient time, and/or force an unsustainable reduction in income over a prolonged bear, and/or ravage the long-term value by forced sale of equities during an adverse sequence of returns.

Withdrawals required within 5 years should be held in cash IMO. The FI allocation may be dependent on tolerance to volatility, and/or ability to reduce/suspend withdrawals for x years looking forward 5/10 years, but should not be a product of an arbitrary value ascribed to any guaranteed income.

There may be many reasons to continue drawdown during a bear market even assuming guaranteed income sufficient to cover expenses comfortably. For example, taking advantage of tax thresholds and/or managing withdrawals to avoid a potential breach of the LTA. Perhaps there is a need to front-load drawdown over a specific period or, maybe, a desire to continue financing discretionary spends uninterrupted throughout retirement. 

Forced selling of equities, or suspending drawdown (even with a cash buffer) each time the market drops, strikes me as a very risky de-accumulation strategy. Both could be the outcome of a too high equity allocation.

Case in point...

If we gave our £30k p.a. DB a FI value of £600k and included it in our portfolio, it would represent approx 45% of the total. A 55/45 portfolio is below our tolerance to risk despite a presumed 100% allocation to equities in the real portfolio.

We need to drawdown in a tax efficient way and that means annual withdrawals to use tax thresholds. I don't fancy a gamble on market timing each time we wish to make a withdrawal as any such withdrawal would require an equity sale. Yes, we could suspend drawdown and use a cash buffer but we don't wish to do that for more than a year as we will lose tax allowances.

The reality is that the guaranteed income allows us to take more risk with the asset allocation so we are 80% equities but the near-term (7/10 years) of drawdown is de-risked in the remaining 20% allocated to cash/FI/WP.

[Deleted User]

MK62 said:

Deleted_User said:

MK62 said:

Deleted_User said:

MK62 said:

DT2001 said:

60/40 was just an example. It should be “whatever is appropriate” for you.  My point is that DB income is a type of FI and should be counted as such towards your desired allocation. Ignoring it introduces massive distortions. 

I dont say ignore guaranteed income when designing your retirement portfolio, quite the reverse.  It's just that you dont need to convert it via a dodgy calculation into a hypothetical bond in order to do this.  

As Linton points out if the amount required was low then a perceived lower risk (higher bond allocation) strategy could be used without any distortion when interest rates changed. BUT if you only needed a say 1 or 2% withdrawal rate a 100% equity portfolio would (on historical data) be risk free. 

......but on the same basis, so would a 60/40 portfolio...or an 80/20...or a 30/70....all would have met your income objective!

Let’s say you bought an annuity with half of your money.  Does it mean that the invested portion of your portfolio needs to be split between FI and Equity in the same proportion as before the purchase?

No, and nobody has said that.......but neither would this then automatically dictate 100% equity either.

You may be likely to have a higher equity content than before though, granted........

You could reverse that though and ask if someone is meeting their income objectives with a 60/40 portfolio, should they move to 100% equities purely on the basis it might give them a higher value portfolio to pass on?

That’s a separate issue.  There are long and short term risks. If you can handle short term risks (eg because you have a salary and are far from retirement) then equities are a better vehicle because bonds are riskier in the long term. 
But you don’t have 100% equity if most of your income needs come from DB sources.  

....but if you have a salary and are far from retirement, you probably won't be drawing down income anyway, and won't be buying an annuity with half your pot either.

I don't think anyone is saying that if you are still in the accumulation phase of your investment journey, and many years from drawdown, you'd construct your portfolio in the exact same manner as you would once retired and into drawdown.........in the former case, equity downturns aren't such a big deal, and are often actually more of an opportunity (as you buy more units with your contributions)......but in the latter case, equity downturns, especially big ones, are far more of an issue.

In the former case, the priority might be maximising returns, while in the latter, the priority might change to minimising risk (and there are, of course, many shades between the two).

But its exactly the same in terms of asset allocation if you are:
1. a thirty year old with decades of salary income to come and
2. A retiree with all your basic needs covered by DB income forever. 

Your education is like your bond. You are getting return on it. Its large compared to your overall portfolio/net worth.  The only reason you should invest in a volatile asset is because you have this income.  You are FI rich; you should buy zero bonds, except to have a bit of cash for short term needs.  If you are an unskilled unemployed with an inherited cash pot, your timeline is different. Different risks. Different asset allocation. 

Same goes for retirees with DB pensions. 

Linton

Deleted_User said:

Linton said:

Deleted_User said:

Linton said:

Deleted_User said:

MK62 said:

DT2001 said:

60/40 was just an example. It should be “whatever is appropriate” for you.  My point is that DB income is a type of FI and should be counted as such towards your desired allocation. Ignoring it introduces massive distortions. 

I dont say ignore guaranteed income when designing your retirement portfolio, quite the reverse.  It's just that you dont need to convert it via a dodgy calculation into a hypothetical bond in order to do this.  

As Linton points out if the amount required was low then a perceived lower risk (higher bond allocation) strategy could be used without any distortion when interest rates changed. BUT if you only needed a say 1 or 2% withdrawal rate a 100% equity portfolio would (on historical data) be risk free. 

......but on the same basis, so would a 60/40 portfolio...or an 80/20...or a 30/70....all would have met your income objective!

Let’s say you bought an annuity with half of your money.  Does it mean that the invested portion of your portfolio needs to be split between FI and Equity in the same proportion as before the purchase?

It certainly doesnt follow that if you were previously 50% equity, 50% bonds you should switch to 100% equity since the bond tranche is now occupied by your annuity.

So you are considering annuity as part of your FI. How is DB income different?  

And if the bond tranche is occupied by annuity, why not switch to 100% equity for the rest? I am confused. 

Err, no.  You are wanting to consider guaranteed income such as the DB pension and thus presumably the annuity as part of your FI portfolio.  If you do that then surely my logic applies that since your annuity gives you 50% of "FI" you should have the rest as equity.  Having 0% real FI in a portfolio with a requirement to drawdown whatever expenditure is not covered by the DB pensions and the annuity seems too risky for me.

I take the opposite view.  Neither the annuity not the DB pension have anything to do with FI in a portfolio.  You need to base your allocations on the amount of drawdown income you need to extract from your actual nvestment portfolio.

Granted, you need a cash buffer for short term needs on top of your annuity (assuming it does not cover all your needs). 

But keeping unnecessarily large amount in FI is risky.  If a retiree with most of his income in DB pension were to put most of his pot into bonds or cash, that pot has a very high probability of losing him a lot of money in real terms in 20 years’ time. He is destroying value.  

The reason you would buy an annuity is that it would give you a lot more flexibility to manage short term fluctuations associated with the equities.  Your equities won’t be down in real terms 20 years’ on.  

Compartmentalizing your assets and treating them independently can lead to poor asset allocation.  

In retirement you need a very different mindset to that whilst working.  Retirement investing puts particular emphasis on the medium term, a timeframe that I do not believe is covered adequately in the literature.  For a start as far as I am concerned 20 years is in the far distant possibly unattainable future.  It doesnt matter if investments are down from their current value as long as there is more than enough to support our current standard of living for the rest of our days and provide for the occasional extravagence.  More income would not improve our lifestyle.

Perhaps the key objective of investing in retirement is security of income.  The need to cut back on basic expenditure is a much more significant indication of failure of one's investment strategy than not maximising wealth at death.  The latter really is irrelevent.

The reason one would buy an annuity is to reduce risk.  The downsides are the cost and the loss of flexibility - one has fewer assets with which to do other things.  By having a buffer of 5 years cash and 5 years low volatility inflation matching investments with an 100% equity poirtfolio in reserve I am happy that  I can support an annuity level of income with fewer assets and only a marginal increase in risk.

I disagree that compartmentalising assets according to objective leads to poor asset allocation.  Quite the contrary.  It provides a specific purpose for each asset.  This makes it easier to assess current assets and choose new ones. It also  enhances diverification as different objective leads to very different types of asset.

With a 60:40 portfolio why 60:40 rather than 70:30 or 50:50 or even 40:60? What is the justification that leads to the chosen numbers? What, under current circumstances, is the bond component doing other than sitting there not being equity?  Compartmentalisation provides answers to all such questions and reduces the need for very arbitrary choices.

[Deleted User]

DairyQueen said:

Linton said:

Deleted_User said:

Linton said:

Deleted_User said:

MK62 said:

DT2001 said:

60/40 was just an example. It should be “whatever is appropriate” for you.  My point is that DB income is a type of FI and should be counted as such towards your desired allocation. Ignoring it introduces massive distortions. 

I dont say ignore guaranteed income when designing your retirement portfolio, quite the reverse.  It's just that you dont need to convert it via a dodgy calculation into a hypothetical bond in order to do this.  

As Linton points out if the amount required was low then a perceived lower risk (higher bond allocation) strategy could be used without any distortion when interest rates changed. BUT if you only needed a say 1 or 2% withdrawal rate a 100% equity portfolio would (on historical data) be risk free. 

......but on the same basis, so would a 60/40 portfolio...or an 80/20...or a 30/70....all would have met your income objective!

Let’s say you bought an annuity with half of your money.  Does it mean that the invested portion of your portfolio needs to be split between FI and Equity in the same proportion as before the purchase?

It certainly doesnt follow that if you were previously 50% equity, 50% bonds you should switch to 100% equity since the bond tranche is now occupied by your annuity.

So you are considering annuity as part of your FI. How is DB income different?  

And if the bond tranche is occupied by annuity, why not switch to 100% equity for the rest? I am confused. 

Err, no.  You are wanting to consider guaranteed income such as the DB pension and thus presumably the annuity as part of your FI portfolio.  If you do that then surely my logic applies that since your annuity gives you 50% of "FI" you should have the rest as equity.  Having 0% real FI in a portfolio with a requirement to drawdown whatever expenditure is not covered by the DB pensions and the annuity seems too risky for me.

I take the opposite view.  Neither the annuity not the DB pension have anything to do with FI in a portfolio.  You need to base your allocations on the amount of drawdown income you need to extract from your actual nvestment portfolio.

Agree with Linton and others upthread. The percentage of non-equities in a portfolio should be a product of the individual's drawdown plan (schedule and values). Including guaranteed income within the FI allocation could result in a too-high equity allocation. This could mean, at best, suspension of drawdown at an inconvenient time, and/or force an unsustainable reduction in income over a prolonged bear, and/or ravage the long-term value by forced sale of equities during an adverse sequence of returns.

Withdrawals required within 5 years should be held in cash IMO. The FI allocation may be dependent on tolerance to volatility, and/or ability to reduce/suspend withdrawals for x years looking forward 5/10 years, but should not be a product of an arbitrary value ascribed to any guaranteed income.

There may be many reasons to continue drawdown during a bear market even assuming guaranteed income sufficient to cover expenses comfortably. For example, taking advantage of tax thresholds and/or managing withdrawals to avoid a potential breach of the LTA. Perhaps there is a need to front-load drawdown over a specific period or, maybe, a desire to continue financing discretionary spends uninterrupted throughout retirement. 

Forced selling of equities, or suspending drawdown (even with a cash buffer) each time the market drops, strikes me as a very risky de-accumulation strategy. Both could be the outcome of a too high equity allocation.

Case in point...

If we gave our £30k p.a. DB a FI value of £600k and included it in our portfolio, it would represent approx 45% of the total. A 55/45 portfolio is below our tolerance to risk despite a presumed 100% allocation to equities in the real portfolio.

We need to drawdown in a tax efficient way and that means annual withdrawals to use tax thresholds. I don't fancy a gamble on market timing each time we wish to make a withdrawal as any such withdrawal would require an equity sale. Yes, we could suspend drawdown and use a cash buffer but we don't wish to do that for more than a year as we will lose tax allowances.

The reality is that the guaranteed income allows us to take more risk with the asset allocation so we are 80% equities but the near-term (7/10 years) of drawdown is de-risked in the remaining 20% allocated to cash/FI/WP.

Ok, so you are actually saying the exact same thing I am.  You can use different maths but its important to account for DB income in deciding equity allocation in the rest of your assets.  You are effectively accounting for DB income because otherwise you would have had more FI. 

In our case we will have enough DB income between the two of us to get by (when we hit 67; some will kick in at 60). A bit more is always nice though. So I’ll have 3 years’ worth of “a bit more” in cash. And the rest in stocks.  There is zero chance I would have planned to go 100% equity in my liquid portfolio had it not been for DB income. 

Costabit

Well, I am still a little unsure which way I will fall on this.

Retirement/ Redundancy (depending on my mood on any given day) has been forced upon me a couple of years early so am in the early stages of positioning my portfolio.

My initial thoughts were to give my DB pension a “value” of 20 years payments and adjust my investments accordingly to keep a 60/40 ratio, which I can see now would mean the rest of my portfolio would be close to 100% equities. The thought of seeing this equity portfolio dropping by 50% just when I would need to drawdown on it would cause me both financial and mental headaches.

So

My next thought was around deducting the yearly fixed income from my yearly needs and structuring the rest of my assets to provide this need. This would drain my portfolio by 5% a year, something a 75/25 should allow and should be less volatile than the original plan.

I really appreciate all the replies, thoughts, and advice you have provide on this thread. I intend to read and re-read it all again as I can see benefits and pitfalls of both scenarios.

A remarkably interesting set of replies to my conundrum.

mark55man

Agreed - real food for thought.  I am toying with early retirement options and following this thread have explored the "relative costs" of spending my DC pot to allow one year less actuarial reduction (for me 6% per year) on my DB.  This works out at about £1.5K a year extra on DB at a cost of withdrawing 30K (my estimated post work annual expenditure). 

This seems like the flip side of the valuation coin being discussed here as in giving up cash to get income not vice versa.  However as I  also have some inheritance ambitions (ie to leave some not to get some) I need to balance the extent I drain the DC - plus if my DB + SP gets too big, whilst still at Basic rate tax, I would have less slack for drawing down DC funds at BRT. 

The recent threads on annuities and this one, and the endless threads on DB to CETV  have persuaded me of the value of a good chunk of income - enough or nearly enough for basic needs allowing more flex on the remaining DC element.  Taking the DB early and a bit reduced could be useful for LTA purposes although I'm not year that yet.    

DT2001

 Linton said
 In retirement you need a very different mindset to that whilst working.  Retirement investing puts particular emphasis on the medium term, a timeframe that I do not believe is covered adequately in the literature.  For a start as far as I am concerned 20 years is in the far distant possibly unattainable future.  It doesnt matter if investments are down from their current value as long as there is more than enough to support our current standard of living for the rest of our days and provide for the occasional extravagence.  More income would not improve our lifestyle.

What provision, if any, have you made for care costs?
For my mother we’ve utilised the equity released by downsizing and I see that as a reasonable strategy. If you can squeeze a little more income/growth from your portfolio with a minimal increase in volatility should you do so?

Can you explain compartmentalising assets for an objective or give an example as I am unsure of how the approach works. Thank you