Filling the gap to state/db pension using an index linked bond ladder in SIPP - how?

michaels

So the theory is easy, in about 12 year times I will get my state pension which for the sake of simplicity we will say will be worth £10,600 uprated by CPI each year.  I would like to fill the gap between now and then by arranging the funds in my DC pot to pay out £10,600 increasing each year by CPI.  I would like to remove investment risk and invest the fund in such a way as to be  certain of supporting these annual withdrawals.

Because the risk is entirely around inflation it would seem that I need to invest in index linked govt bonds - for example if I were to put aside 12 x 10,600 and invest it in money market funds then it would likely not keep up as these funds seem to generally grow by less than CPI.

So what I need is an 'index linked bond ladder' - easy in theory but in practice how to I know what bonds to buy and how much to invest in each one in terms of initial purchase amount.

So for example which bond would I buy and how much to give 10.6k uplifted by 9 months cpi in Jan 24, which bond and how much for 10.6k uplifted by 21 months cpi in Jan 25 and so on.

Ideally I could then end up with a total price now for filling the gap until state pension becomes payable.

Thanks in advance

Linton

michaels said:

So the theory is easy, in about 12 year times I will get my state pension which for the sake of simplicity we will say will be worth £10,600 uprated by CPI each year.  I would like to fill the gap between now and then by arranging the funds in my DC pot to pay out £10,600 increasing each year by CPI.  I would like to remove investment risk and invest the fund in such a way as to be  certain of supporting these annual withdrawals.

Because the risk is entirely around inflation it would seem that I need to invest in index linked govt bonds - for example if I were to put aside 12 x 10,600 and invest it in money market funds then it would likely not keep up as these funds seem to generally grow by less than CPI.

So what I need is an 'index linked bond ladder' - easy in theory but in practice how to I know what bonds to buy and how much to invest in each one in terms of initial purchase amount.

So for example which bond would I buy and how much to give 10.6k uplifted by 9 months cpi in Jan 24, which bond and how much for 10.6k uplifted by 21 months cpi in Jan 25 and so on.

Ideally I could then end up with a total price now for filling the gap until state pension becomes payable.

Thanks in advance

Yes the theory is that you buy now separate traches of inflation linked bonds at known prices that mature in 1 year, 2 years etc up to 12 in your case.  However in practice there will be complications since you wont find a set of  IL bonds available that expire at yearly intervals.  So you will have to sort out a plan using what is available that works well enough.

You can find a list of IL bonds on the HL website - see https://www.hl.co.uk/shares/corporate-bonds-gilts/bond-prices/uk-index-linked-gilts?column=maturity&order=asc

I think the list is complete but am not 100% sure.

A further complication is that you will not be buying at par.  Almost any bond with a listed price above or below  £100 will actually return about 100/price X inflation.  There are further complications with bond pricing regarding "clean" and "dirty" prices you will need to understand but they wont affect your returns.  The price listed on the HL website is generally the "clean" price but any bonds listed at well over £100, say £300, will be dirty priced and the simple formula wont work.

Note that this at the moment is just an idea.  It will work, but since IL medium/long dated bonds have only recently been priced at close to par as far as I know no-one has actually implemented it.

najan49

I was wondering about this myself the other day. 

I came to the conclusion that it’s basically just £10,600 in each bond, and you’ll get you capital back with a RPI-uplift. The coupons are presumably not material/factored into the price paid at purchase?

There is basically only one linker in issue per redemption year. There are a few years without, such as 2025 & 2030. For those years I assume you buy double the amount of the 2026 or 2031 and sell the relevant amount as appropriate?

https://www.dmo.gov.uk/data/pdfdatareport?reportCode=D1D

Linton

najan49 said:

I was wondering about this myself the other day. 

I came to the conclusion that it’s basically just £10,600 in each bond, and you’ll get you capital back with a RPI-uplift. The coupons are presumably not material/factored into the price paid at purchase?

There is basically only one linker in issue per redemption year. There are a few years without, such as 2025 & 2030. For those years I assume you buy double the amount of the 2026 or 2031 and sell the relevant amount as appropriate?

https://www.dmo.gov.uk/data/pdfdatareport?reportCode=D1D

Yes the price at purchse is affected by the coupon (interest).  High coupon bonds cost more.  But I was purely considering the capital to provide some simplicity since for most IL bonds the coupon is very low.

najan49

Yes agreed.

Turns out there is a 2030 linker, but it was shown at the bottom of the list as it is on 8-month basis whereas more recent issues are on 3-month.

OldScientist

Putting £10.6k into each maturity (with double for the ones before a gap) will, given real yields to maturity are slightly above 0% (at the end of last week, according to https://reports.tradeweb.com/closing-prices/gilts/ they were about 0.5-0.6% for the ones towards the end of a 12 year ladder) provide roughly equivalent spending power. Since the rate is above 0%, neglecting coupons (which are fairly small for the most part), this means that the real value of the maturing bond will actually be slightly above £10.6k (~11.1k after 10 years assuming 0.5% ytm).

I built a short ladder (more of a step!) last year to cover the potential effects of inflation on life insurance towards the end of the current decade.

Note that as well as a different way of being priced to the more recently issued bonds and the different inflation lag mentioned above (8 months compared to 3 months), the 2030 linker also has a much higher coupon (4.125%).

michaels

Thanks all. 

So the ones paying a coupon of 0.125% are probably the easiest as there is least issue with the coupon payments along the way so by far the majority of the value is from the index linked payment on maturity.

However even for these and to a much larger extent for the ones paying a bigger coupon (especially that 2030 one paying 4.5%) we would need to factor in that some of the returns are paid annually as coupons rather than as an index linked final value.  Does anyone know if the coupons are paid as a percentage of the initial value of the nominal value of the bond or do they get increased by the level of inflation to date?

How about a worked example, say that 2030 bond was the last in the ladder so it would need to pay out the full index linked 10.6k on maturity, how much would need to be purchased today and what other cashflows would it generate annually earlier that would need to be taken off the purchase amount of the previous year purchases to avoid receiving too big an income?

michaels

OldScientist said:

Putting £10.6k into each maturity (with double for the ones before a gap) will, given real yields to maturity are slightly above 0% (at the end of last week, according to https://reports.tradeweb.com/closing-prices/gilts/ they were about 0.5-0.6% for the ones towards the end of a 12 year ladder) provide roughly equivalent spending power. Since the rate is above 0%, neglecting coupons (which are fairly small for the most part), this means that the real value of the maturing bond will actually be slightly above £10.6k (~11.1k after 10 years assuming 0.5% ytm).

I built a short ladder (more of a step!) last year to cover the potential effects of inflation on life insurance towards the end of the current decade.

Note that as well as a different way of being priced to the more recently issued bonds and the different inflation lag mentioned above (8 months compared to 3 months), the 2030 linker also has a much higher coupon (4.125%).

The tradeweb link seems to require a log in, but if the real yields are positive in theory you could discount the final amount by the real yield to come up with a slightly smaller amount needed for investment now, for example perhaps only invest 10.1k in the 12 year one as per your example?

Qyburn

Just as a real basic question, the top bond on that list GB00B85SFQ54 has a price of £97.85 and maturity of 22 March 2024.  If you buy that, you pay £97.85, and next March you get what, £100 indexed by RPI since when? 

najan49

This is my current understanding which could be way out!

£97.85 is the clean price, you will actually pay the dirty price which is about £151.30.

The redemption price would be 100 * RPI at (22 Dec 2023) / reference index (242.42ish)

if the RPI stayed the same between now and December (it won’t) the input value for RPI would be 376.4 and so the redemption price would be about £155.26. Plus a tiny coupon.


Actual reference index is on the prospectus here: https://www.dmo.gov.uk/media/dlvn3pc5/pr021012b.pdf
RPI is here https://www.ons.gov.uk/economy/inflationandpriceindices

michaels

najan49 said:

This is my current understanding which could be way out!

£97.85 is the clean price, you will actually pay the dirty price which is about £151.30.

The redemption price would be 100 * RPI at (22 Dec 2023) / reference index (242.42ish)

if the RPI stayed the same between now and December (it won’t) the input value for RPI would be 376.4 and so the redemption price would be about £155.26. Plus a tiny coupon.


Actual reference index is on the prospectus here: https://www.dmo.gov.uk/media/dlvn3pc5/pr021012b.pdf
RPI is here https://www.ons.gov.uk/economy/inflationandpriceindices

So do we know what the clean price represents?  Is it some sort of rebasing?  What tells us that the current real yield is +0.5% or whatever as per Old Scientists posts?

Plus again how do we model the coupons?  Seems to me there is probably a spreadsheet out there already with all this stuff in it.