Index linked gilts and index linked annuities: are you moving money into them, yea or nay?

SnowMan

In the future I've got two small final salary pensions and a state pension that will come into payment. Only the state pension will increase with inflation. The increases on the final salary pensions are effectively inflation linked in deferment but after they come into payment at 60 and 65 the increases are capped and so could get eroded by a period of high inflation or hyperinflation. Even if the final salary pensions were inflation linked in payment (which they are not) I would need to top up my income from these three sources in the future from my investments and savings.

I estimate I can meet my requirements for income in retirement even if I live to a good age and experience significant negative real returns on my investments and savings.

Recently I have been invested in a mix of regional equity index tracker funds together with some money in savings accounts. I've never held conventional gilts or gilt funds etc and until now never held index linked gilts (ILGs). I don't have a large SIPP because I went the ISA/GIA route when I was self-employed, and post the 2015 pension freedoms I only did some low paid part-time work so even after then contributing 100% of my salary not much has gone into the SIPP. And what has gone in should have come out within my personal allowance before my secure income kicks in. An index linked annuity isn't an option unless I opt for a purchased life annuity which I won't be doing. 

I've moved 14% of my investment portfolio into the 2042, 2048 and 2051 maturity ILGs which I intend to hold to maturity. So not a gilt ladder, but just strategically moving money out there to when I might need it and giving me some protection against inflation up to 2051. Because I don't need to achieve anywhere near the roughly 1.5% real return above CPIH inflation that those ILGs should provide, it provides a small level of cushioning for the remaining portfolio.

If real returns on ILGs were to increase to 2% then I would consider increasing my holding of ILGs but I can't see it ever going above 30%. For all the careful calculations and planning you can't know what income you might need in the future or what unexpected events or changes to taxation might happen and going too 'safe' can cause its own problems rather than trying to further increase the buffer.  

zagfles

FIREDreamer said:

zagfles said:

I'm now at the stage where DB plus state pension provides the core income we need, but I'm using IL gilts for 2 purposes, firstly to provide a gilts ladder to replicate the state pension for the years between retirement and state pension age, and secondly some very long dated IL gilts as a hedge against high inflation reducing the value of our DB pensions. 

I don't think people with DB pensions understand how much they can get decimated by inflation, unless they have uncapped inflation increases. The vast majority of private sector DB pensions cap inflation increases to 3% or 5%. A few years of high inflation could put a serious dent in the real value of the pension. Just one year of 10% inflation would chop 7% off a DB pension with a 3% cap, or 5% if the cap is 5%, and that's a permanent cut for the rest of your life. A decade like the 70's would over halve its value. 

An uncapped RPI annuity will do some of that, though won’t help with the real reduction in the DB pension of course (nor will the ILG really)

My logic is that if we did go through a sustained period of high inflation, IL gilts would rise in value as their (nominal) return would probably be better than most investments. In any case, they hedge IL annuity rates, and I might end up using them to buy one. 

zagfles

SnowMan said:

In the future I've got two small final salary pensions and a state pension that will come into payment. Only the state pension will increase with inflation. The increases on the final salary pensions are effectively inflation linked in deferment but after they come into payment at 60 and 65 the increases are capped and so could get eroded by a period of high inflation or hyperinflation. Even if the final salary pensions were inflation linked in payment (which they are not) I would need to top up my income from these three sources in the future from my investments and savings.

I estimate I can meet my requirements for income in retirement even if I live to a good age and experience significant negative real returns on my investments and savings.

Recently I have been invested in a mix of regional equity index tracker funds together with some money in savings accounts. I've never held conventional gilts or gilt funds etc and until now never held index linked gilts (ILGs). I don't have a large SIPP because I went the ISA/GIA route when I was self-employed, and post the 2015 pension freedoms I only did some low paid part-time work so even after then contributing 100% of my salary not much has gone into the SIPP. And what has gone in should have come out within my personal allowance before my secure income kicks in. An index linked annuity isn't an option unless I opt for a purchased life annuity which I won't be doing. 

I've moved 14% of my investment portfolio into the 2042, 2048 and 2051 maturity ILGs which I intend to hold to maturity. So not a gilt ladder, but just strategically moving money out there to when I might need it and giving me some protection against inflation up to 2051. Because I don't need to achieve anywhere near the roughly 1.5% real return above CPIH inflation that those ILGs should provide, it provides a small level of cushioning for the remaining portfolio.

If real returns on ILGs were to increase to 2% then I would consider increasing my holding of ILGs but I can't see it ever going above 30%. For all the careful calculations and planning you can't know what income you might need in the future or what unexpected events or changes to taxation might happen and going too 'safe' can cause its own problems rather than trying to further increase the buffer.  

Yes they're quite a good investment to hold unwrapped as you only pay tax on the small coupon, not on the capital gain. But I think if you bought a PLA you'd pay tax on all the interest/growth element, so holding unwrapped IL gilts seems to be much more tax efficient than PLAs. Although you miss out on the longevity insurance of course. 

najan49

zagfles said:

I'm now at the stage where DB plus state pension provides the core income we need, but I'm using IL gilts for 2 purposes, firstly to provide a gilts ladder to replicate the state pension for the years between retirement and state pension age, and secondly some very long dated IL gilts as a hedge against high inflation reducing the value of our DB pensions. 

I don't think people with DB pensions understand how much they can get decimated by inflation, unless they have uncapped inflation increases. The vast majority of private sector DB pensions cap inflation increases to 3% or 5%. A few years of high inflation could put a serious dent in the real value of the pension. Just one year of 10% inflation would chop 7% off a DB pension with a 3% cap, or 5% if the cap is 5%, and that's a permanent cut for the rest of your life. A decade like the 70's would over halve its value. 

As I mentioned on another thread, my dad dies 3 months ago. When I went through his papers, I discovered that only a small part of his Ford Motor Company DB pension (GMP presumably) had any increases at all. He was retired for 31 years and his initial pension was about £12,000 pa and he ended up with about £15,500 pa.

If his pension had increased in line with RPI it would have been closer to £32,000 I think - so it more than halved in value during his retirement.

Fortunately inflation was relatively benign over this period - the 70s would have been catastrophic.

Hoenir

In 2022 plenty of people who thought that they understood ILG's came unstuck. Certainly far from being straightforward to comprehend. From my personal perspective best left to pension funds or as part of a managed portfolio. More than happy to stick to conventional Gilts where there's complete certainty as to the outcome. 

zagfles

Hoenir said:

In 2022 plenty of people who thought that they understood ILG's came unstuck. Certainly far from being straightforward to comprehend. From my personal perspective best left to pension funds or as part of a managed portfolio. More than happy to stick to conventional Gilts where there's complete certainty as to the outcome. 

IL gilts may take a bit of getting your head around but really aren't that complicated for anyone who's capable of managing investments. And there's no certainty of how much a conventional gilt will really be worth in the future. 

najan49

Hoenir said:

More than happy to stick to conventional Gilts where there's complete certainty as to the outcome. 

Complete certainty about everything, except the spending power.

SnowMan

Hoenir said:

In 2022 plenty of people who thought that they understood ILG's came unstuck. Certainly far from being straightforward to comprehend. From my personal perspective best left to pension funds or as part of a managed portfolio. More than happy to stick to conventional Gilts where there's complete certainty as to the outcome. 

I think a lot of people are confused by index linked gilts. You have to think that that, and the fact they haven't typically been bought by private investors, and that they have until recently offered negative real yields, explains why people are willing to accept a significant risk, that of the erosion of their capital through higher than expected inflation. It's a risk that can be mitigated through index linked gilts.

The basic principle of index linked gilts is straightforward. I'll make up an example.

Two sisters Indiana and Connie need to invest to cover expenditure on food, energy, petrol etc in 20 years time, items that currently cost them £10,000.

Indiana invests £10,000 today in say a 0.125% 20 year term index linked gilt that has a maturity real yield of say 1.5%pa. She holds it to maturity, and gets back in 20 years time her £10,000 plus inflation plus a little bit more, as well as some very small interest payments along the way. She has enough money to cover her food, energy, petrol etc, because while although all those things have gone up with inflation, so has her investment. In fact she's got a little bit left over as well.

Connie instead invests £10,000 in a 20 year conventional gilt, let's assume it's a zero coupon gilt just to keep the explanation simple. She gets back £10,000 plus 4.9%pa in 20 years time (4.9%pa being the yield to maturity the gilt is priced at).

Let's suppose 20 year inflation averages 6%pa, which is higher than current expectations of inflation priced into prices of say 3.4%pa. Connie in 20 years time gets back £26,000 (£10,000 plus 4.9%pa for 20 years) from her conventional gilt. It's not enough to cover her food, energy and petrol which now cost £32,000 (£10,000 plus 6%pa for 20 years). Fortunately her sister Indie helps her out with the little bit left over from her investment which after reinvesting the small coupon payments is now worth just over £42,000 and more than covers her own food, energy and petrol which now cost £32,000.

If 20 year inflation averages 3%pa instead Connie has got back the same £26,000 from her conventional gilt, it's more than enough to cover her food, energy and petrol which costs £18,000 (£10,000 plus 3%pa for 20 years). She has slightly more money than Indie who only has £24,000, but Indie still has more than she needs to cover her own £18,000 food, energy and petrol bills so doesn't need any help from her sister.

Whatever happens with inflation Connie has complete certainty in knowing what she will get back in 20 years (£26,000). Indie has complete certainty that she can pay for her food, energy and petrol.

Which of these certainties would you prefer?

Bobziz

And what can we say about the markets ability to reliably forecast inflation? If it's reliable then conventional gilts provide the highest yield don't they?

OldScientist

In answer to the question, yes - I have a short ladder to provide an inflation linked boost to the nominal life insurance payout should I die before my OH receives their state pension. We haven't needed an annuity since I have a DB pension (75% of which is fully CPI protected with the remaining 25% inflation capped).

More generally, for those who require additional inflation linked income beyond their state pension and any DB pensions that is not dependent on market outcomes there are effectively two choices. An inflation linked annuity or a collapsing ladder of inflation linked bonds (i.e., where coupons and maturing bonds are used as income and not reinvested).

Annuity payout rates (beginning of October at https://www.williamburrows.com/calculators/annuity-tables/) are around for joint life (100% survivor benefits, 5 year guarantee) 3.4% and  3.8% at 60 and 65, respectively, and for single life 3.9% and 4.6% (at 60 and 65).

Using the tool at https://lategenxer.streamlit.app/Gilt_Ladder an index linked gilt ladder that ends at 100yo would have payout rates of 3.1% and 3.5% at 60 and 65, respectively.

Purely from an income point of view, the annuity (particularly for single retirees) is better than the ladder although any legacy considerations are more involved (although a 20 year guarantee period doesn't actually make that much difference to the joint payout rates).

On the other hand, the SWR for a 35 or 40 year planning horizon starting now (or anytime over the last decade) is unknown. While historical values for a 50/50 portfolio of stocks/short term fixed income were about 2.9% and 3.3% (e.g., see https://www.2020financial.co.uk/pension-drawdown-calculator/ ) at 60 and 65yo, respectively, these are not guaranteed. While the exact historical numbers can (and are) argued about, it does not change the fact that future values are unknown and unknowable.

One particular useful feature of a guaranteed income floor is that once it meets essential spending (however that is defined), portfolio income can be variable which is more robust than the constant inflation adjusted withdrawals assumed by SWR.