Creating a Gilt ladder for income

incus432

In another thread on here where I was enquiring about fixed term annuities, Zagfles made the suggestion below. I felt that this was well beyond my experience and expertise and comfort zone, and we did go for the annuity in the end, to plug an 8 year income gap.

zagfles said:

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Have you looked into a gilts ladder instead, the "mortality premium" for a fixed term annuity up to SPA may not be that great particularly if it has spouse protection, unless you/spouse are in poor health. Also it seems index linked fixed term annuities are quite hard to find - which if you want to (sort of) replicate the state pension are what you really need. But doing an IL gilts ladder is not too hard if you're used to managing investments yourself and are handy with a spreadsheet

Since then however, and for my own interest I have been trying to understand this topic better by reading (inc Monevator https://monevator.com/index-linked-gilt-ladder), watching various YouTube videos (eg PensionCraft https://www.youtube.com/watch?v=UqrO9Wi6rSY). 

Any other recommendations? I understand the pros and cons of doing this inside or outside an ISA or SIPP but there seem to be lots of potential pitfalls in selecting gilts and creating such a ladder even after getting your head around the jargon of clean and dirty prices, coupons, YTM etc etc.

The first question I have would be - is it worth it? Would it give you more income than the FT annuity? I am trying to work this out on a hypothetical example of a 100k pot invested into a ladder over 10 years, with nothing left at the end. 

Any thoughts?

MK62

There's a tool here that you might find useful for your research https://lategenxer.streamlit.app/Gilt_Ladder

incus432

Thanks - that is very useful. 

It shows that with the same pot the gilt ladder delivers almost exactly the same income as the annuity (cash interest set to zero). If you set the cash interest to 3% the pot needed is 0.55% less on the gilt ladder. Certainly not enough of a differential to merit the considerable hassle.

On-the-coast

I have done no research (apologies!)
but as I understand it an annuity is a blunt instrument - you get what you pay for, and you can’t unwind your decision once purchased.  

Can you unwind / sell a gilt ladder once established.  Does it form part of your estate?

incus432

Not an expert obvs but a gilt ladder is just a package of UK government bonds with different maturity dates and the idea is that they are usually held to maturity. I assume you could sell them at any point but what you'd get for them is uncertain, depending on interest rates then. I assume they are part of your estate. 

OldScientist

incus432 said:

In another thread on here where I was enquiring about fixed term annuities, Zagfles made the suggestion below. I felt that this was well beyond my experience and expertise and comfort zone, and we did go for the annuity in the end, to plug an 8 year income gap.

The first question I have would be - is it worth it? Would it give you more income than the FT annuity? I am trying to work this out on a hypothetical example of a 100k pot invested into a ladder over 10 years, with nothing left at the end. 

Any thoughts?

It is impossible to determine in advance whether the fixed term nominal fixed term annuity or the inflation linked gilt ladder will give the highest income over the N year period since it depends realised inflation. If inflation turns out to be higher than some threshold, then the ladder is likely to win while if inflation is lower than that threshold then the annuity will win. However, given that deflation is rare, the consequences of high inflation on annuity income will be more serious.

DRS1

I confess that I do not understand how a gilt ladder could be constructed as a proxy for an annuity.  With the annuity you get a monthly income of equal amounts (perhaps increasing annually if you pick that option).  With a gilt ladder most of the return is on maturity of the gilt (the coupons are usually peanuts especially on Index Linked Gilts).  So if you wanted monthly income you would have to buy gilts maturing one month apart!  For an 8 year period that is 96 different investments (assuming you could find that many maturing with that frequency which I doubt).  Think of the commission!
OK Pensioncraft talk about a ladder with gilts maturing a year apart.  Fine so just 8 needed as long as you can save up your expenditure till the end of the year.  But then he goes on about reinvesting the maturity proceeds - so is the ladder meant to go on for ever?  And are you meant to live on the coupons?  You'd need an awfully big investment to give you a decent income from just coupons alone.   I understand that is not what you are trying to mirror - you are prepared to spend capital as well as income over the period but with annually maturing gilts you are going to get lumpy returns.  Do let us know what you come up with. 

incus432

DRS1 said:

I confess that I do not understand how a gilt ladder could be constructed as a proxy for an annuity.  With the annuity you get a monthly income of equal amounts (perhaps increasing annually if you pick that option).  With a gilt ladder most of the return is on maturity of the gilt (the coupons are usually peanuts especially on Index Linked Gilts).  So if you wanted monthly income you would have to buy gilts maturing one month apart!  For an 8 year period that is 96 different investments (assuming you could find that many maturing with that frequency which I doubt).  Think of the commission!
OK Pensioncraft talk about a ladder with gilts maturing a year apart.  Fine so just 8 needed as long as you can save up your expenditure till the end of the year.  But then he goes on about reinvesting the maturity proceeds - so is the ladder meant to go on for ever?  And are you meant to live on the coupons?  You'd need an awfully big investment to give you a decent income from just coupons alone.   I understand that is not what you are trying to mirror - you are prepared to spend capital as well as income over the period but with annually maturing gilts you are going to get lumpy returns.  Do let us know what you come up with. 

I assume the idea is to to take the annual income and put it into an account to be spent through the year.  Like you I dont understand how the ladder ends - I have never seen a practical worked example given.  Anyway I am happy with the choice of FT annuity for my wife - it's simple, guaranteed and doesn't require constant tweaking and rebuying gilts, and foolproof if I lose my marbles or die before her

OldScientist said:

It is impossible to determine in advance whether the fixed term nominal fixed term annuity or the inflation linked gilt ladder will give the highest income over the N year period since it depends realised inflation. If inflation turns out to be higher than some threshold, then the ladder is likely to win while if inflation is lower than that threshold then the annuity will win. However, given that deflation is rare, the consequences of high inflation on annuity income will be more serious.

Yes you're right - I have just compared level FT annuity with a non-inflation-linked gilt ladder, and neither has any protection if inflation takes off. I'm just banking on 8 years being a reasonably short term, and if it happens we have other funds to cover the shortfall.

incus432

On the need for simplicity of finances in retirement this article really struck home for me. Although I havent followed the advice on shifting to ITs, it's a reason for choosing an annuity over a gilt ladder

https://monevator.com/death-infirmity-investing/

"And so I shall continue to gradually transition my SIPP portfolio into income-centric investments, believing that in doing so I’m addressing two risks.

• One, generating an income if gagadom strikes.

• Two, leaving my spouse with a straightforward means of redirecting that income to her own bank account should I suddenly keel over.

But to be frank, there’s another reason, too.

The last thing I want is for her to be faced with a situation so unmanageable that she calls in a smart-suited ‘adviser’, who might persuade her to switch the whole lot into some ghastly under-performing fee-laden ‘product’.

Meaning that having out-smarted the investment professionals in life, I can continue to do so in death, too."

Linton

With an IL gilt ladder you buy a set of gilts that mature about 1 year apart.  As each matures you put the proceeds into cash and live off that.

IL gilts only match or exceed inflation if you buy them at par or less and keep to maturity.  If you sell prior to maturity anything could happen, inflation matching is certainly not guaranteed.  If you pay more than par you will make a partial capital loss at maturity.  Now you can buy IL gilts at par, 5 years ago your couldn't.  IL gilts are priced such that their total return, given inflation matches market expectations, is equivalent to the return from fixed rate gilts.  If fixed rate interest rates are below expected inflation then IL bonds will be priced above par.

So to provide long term inflation protection you would need to buy a large number of IL gilts spread over perhaps decades now, just as with an annuity. On the other hand, except for the unlikely event of hyper-inflation, are you really bothered about the first few years?  Unless your plans are very tight a few years inflation should not be a problem. It is long term inflation that can destroy a retirement plan.

In my view global equity forms a better solution to dealing with long term (> 10 years)  inflation.

OldScientist

incus432 said:

DRS1 said:

I confess that I do not understand how a gilt ladder could be constructed as a proxy for an annuity.  With the annuity you get a monthly income of equal amounts (perhaps increasing annually if you pick that option).  With a gilt ladder most of the return is on maturity of the gilt (the coupons are usually peanuts especially on Index Linked Gilts).  So if you wanted monthly income you would have to buy gilts maturing one month apart!  For an 8 year period that is 96 different investments (assuming you could find that many maturing with that frequency which I doubt).  Think of the commission!
OK Pensioncraft talk about a ladder with gilts maturing a year apart.  Fine so just 8 needed as long as you can save up your expenditure till the end of the year.  But then he goes on about reinvesting the maturity proceeds - so is the ladder meant to go on for ever?  And are you meant to live on the coupons?  You'd need an awfully big investment to give you a decent income from just coupons alone.   I understand that is not what you are trying to mirror - you are prepared to spend capital as well as income over the period but with annually maturing gilts you are going to get lumpy returns.  Do let us know what you come up with. 

I assume the idea is to to take the annual income and put it into an account to be spent through the year.  Like you I dont understand how the ladder ends - I have never seen a practical worked example given.  Anyway I am happy with the choice of FT annuity for my wife - it's simple, guaranteed and doesn't require constant tweaking and rebuying gilts, and foolproof if I lose my marbles or die before her

OldScientist said:

It is impossible to determine in advance whether the fixed term nominal fixed term annuity or the inflation linked gilt ladder will give the highest income over the N year period since it depends realised inflation. If inflation turns out to be higher than some threshold, then the ladder is likely to win while if inflation is lower than that threshold then the annuity will win. However, given that deflation is rare, the consequences of high inflation on annuity income will be more serious.

Yes you're right - I have just compared level FT annuity with a non-inflation-linked gilt ladder, and neither has any protection if inflation takes off. I'm just banking on 8 years being a reasonably short term, and if it happens we have other funds to cover the shortfall.

There is a big difference between a rolling ladder (where maturing gilts and coupons are reinvested) which is essentially similar to a bond fund and a collapsing ladder where coupons and maturing gilts are spent. With the latter it is set up once at the beginning with no need for any work (apart from withdrawing cash out). Unfortunately, this difference is not always made plain.

As an example assume a collapsing nominal ladder designed to last three years is required to provide about £10k each year. Using https://lategenxer.streamlit.app/Gilt_Ladder with number of years set to 2 (more on that in a moment)

At the beginning, you would buy £9.5k of TY25 and £9.3k of T26A. This tool assumes income at the end of each year*, so you would also need to set aside an additional £10k in cash to cover the first year for a total cost of £18.8k).

You would receive £187 in coupons in April 2025 that can be set aside (in cash) for the following year's expenditure

In October 2025, you'd receive an additional £187 in coupons together with the proceeds form the maturing bond giving a total of £10k to spend between October 2025 and October 2026.

In April 2026 you'd receive £19 in coupons with another £19 in October 2026 together with the maturing T26A giving a total of £10k to spend between October 2026 and October 2027.

Assuming this was held in a GIA only the coupons would count for tax purposes. In a SIPP, withdrawals would be taxed depending on whether there was a tax free component or not.

* This is not quite how I would have implemented this for annual withdrawals (there are US example calculators that spend the coupons immediately on receipt), but is good enough for illustration purposes (edit: this is an excellent, and as far as I am aware, unique for the UK, tool so I'm not being critical).  I note that opting for a monthly withdrawal gives a much better, but lengthier, solution (look at the cash flow tab in the online tool, and use 3 years instead of 2).

I'd agree that the FT annuity is simpler and lifetime annuities definitely so (I note that guarantee periods can be used to effect a legacy in the latter case).