Is a Gilt Ladder a Good Thing ?

Been musing on the relative value of a Total Return approach (as advocated by many in the US fatFIRE area) or a more relativistic approach.

Let me explain….

One of the reasons to retire early is to enjoy life, to do what we want to do as opposed to what we have to do. Comes with this the necessary fund streams to allow this to happen. Now if we take a more investment direct approach (as is many a 4% plan), we look at a spread of investments, a generated yield and possibly some capital taken. Depending on our risk appetite we look at higher growth areas and more risky classes of investment.

Nothing wrong with this approach. But in setting up and putting the elements in place to deliver there is a fair amount of work. We subject ourselves to a possibility of sequence risk and we have to keep looking to check on performance. Whether the look is every day, week, month or year, we still need to allocate time and effort to balance, to assess and to action change and revision.

I strongly suspect (as I am not at that point), there is a not inconsiderable amount of work involved and many who go down this path are rather more active investors than passive.

Yes, passive investment strategies exists and many are based around natural yield. Really, having sufficient start fund that only the yield is taken and whether the capital value goes up or down in any one year or so is not that important is the real goal. This still exposes the funds to sequence issues as even a smoothing methodology (such as variable withdrawal) can only work within some limits.

I am (I hope) heading to a point where my total funds would make a purely passive approach straightforward if I choose to do this, but I still have this niggle about time and complexity.

I know when both my mine and my wife state pension kicks in. Assuming I believe the UK government predictor, I have a fair certainty of what that with be for us both I should add: in the UK the issue of affordability is fast becoming large and some level of means testing irrespective of paying in may very well come in – its a risk !

So I know in 12 years a predictable stream of income will be added to the small pension that my wife already gets. If I add just those two then our base costs (Bills, Food, Utilities, property tax etc) are more than met (even allowing for inflation).

Just musing about how much work is involved in investing a large portfolio, what I real have come to the conclusion is that I want a lump of play money, a large lump to fire, forget and grow and a lump that delivers a steady and predictable income stream…. a sort of base-line.

So if I ignore play-money, invest a large lump for a timeframe of 8-10 years+, what I really then need is a rising predictable income stream for 12 years or so to take us to state retirement age.

Enter the treasury bond ladder ….. I had largely worked out a plan and then EarlyRetirementNow (ERN) posted a great wee article (he has a habit of that) with a nice calculator allowing an easy way to fairly accurately predict.

I have stated working out a calculator and scribbling some notes, but frankly, there is zero point posting anything myself as really it says it all. (But a note of caution, it is idealised and really a tool to illustrate and get close).

Low and behold, my wee little brain cell started jumping about all excited and saying to me .. lump .. predictable … de-risk … Suddenly, I could put a lump to one side that generated a predictable and guaranteed income stream that when added to my wife’s predictable work based scheme covers all our basic living costs. I could stop being so concerned about sequence risk and annualised return and focus on long term investment prospects, and just allocate a small amount of time to some play-money-investments.

WOW ! … just never though in those terms before.

I actually started to consider why people would buy treasury bonds yielding a return lower than inflation. I always considered it bonkers, but now .. well… I have a slightly different view.

    • Yes, total return is terrible
    • Yes, actual yield received is likely to be less than inflation
    • Yes, it ties ups a large(ish) sum
    • Yes, there are issues if I pop my clogs for estate and tax
    • Yes, in any sensible long term investment plan it looks a bit nuts.

But …

    • It is predicable
    • It is risk free (essentially gilts are risk free)
    • It requires little or no work once set up
    • It provides a significant income de-risk

For the very first time, I have started to consider that total return is not the be all and end all, and that a balance of risk, effort and reward is not at all a bad thing.

So how might this work?

If we take the view that everything beyond the basic needs is discretionary, ie, whether we buy a new car, go on holiday, build a house extension, go the theatre every week or just plain eat out at fine restaurants, we can stop worrying so much about relative returns. They may vary from year to year and we just make an adjustment. Instead of 3 weeks in Australia, go to Tenerife for a couple of weeks. Instead of a new car, we just pay a much smaller sum for maintenance on what we have, instead of Loch Fyne Sea Food, we go to Cafe Rouge.

A while ago as I started really looking at what I did and want to do, I looked at how I spent and predicted. I have updated further and rather better refined things, but just for the sake of this article and to keep it simple I am just going to say that a range from the bottom end (very thinFIRE) we would ned £20K and top end £25K pa for all the basics and a little beyond that. I exclude mortgage costs as we can pay that off and I will exclude car replacement costs (as exceptional’s). Our lives are not quite like this, but really I want to illustrate a point.

So if I deduct the small pension my wife now gets, we need between £13 and £18K as an income stream.

So looking for a 13 year period (taking us to the year beyond state retirement) , with an income rising by 2% pa, looking at current UK gilt rates start at around 0.75% for a year and rise (slowly). Without embedding a terribly dull table or yield curve (we all know what they look like), I can calculate using ERN’s spreadsheet an average yield of around 1.09% (peanuts I know), and an income stream staring at £13,000, £13,260, £13525 etc to £16,487 at year 13.

The calculator spits out a required investment of just under £178K. The total returned is £191K… so £13K of actual yield spread over 13 years … peanuts really !

At the top end looking for a start of £18K, I get a required sum of £246K.

So what all this says, is that to cover all our household costs for the next 13 years I need to tie up somewhere between £178K and £246K depending on a more detailed look at assumptions and basic living.

    • Do I really want to tie up £0.25M ?
    • Can I afford to tie up £0.25M ?

But the real question is that I will spend the money anyway. What we really should consider is the relative yields we could have and the risks we take for those yields.

For example, If I decided I would use corporate bonds instead of gilts, they start at around 3% for a year (just a brief look). I could potentially average around 4% over the spread. This required an initial investment of £206K

…. so I save £40K in initial investment. Sounds good.. or does it ?

But my risks go through the roof… Instead of needing to buy one gilt for a year I might really need to buy 3/4 or 5 corporate bonds for each year just to mitigate the risk of default. I could expect some to default or buy back upsetting my cash flow. I might look and think I really need to invest more to cover for this risk… another 5% or 10% maybe , so my potential saving is now smaller.

A Gilt investment bond ladder is not as unattractive in the wider context. Higher initial investment is the price of (essentially) zero risk and not having to worry about it.

There is another reason to look at simplification and generating a relatively stable income stream (even if it ties up a lump of capital). As I went through when looking at our costs, we can certainly have a lot of fun and travel with circa £40K net income, then we only need to generate a further income stream of £15K.

Using the classic 4% rule (not really appropriate in the UK but anyway), I need only have a lump sum of circa £375K… a much small amount than £1M+ if I needed to generate all income and cover sequence risk, portfolio spreads and management etc.

What this means is that my investment strategy could be much different if I want be more modest, more risk adverse, and take a much longer time frame view..

 

I started with a notion, that all the research and background reading, all the blogs read and advice just make it all too complicated. I do not want a full time job as an investment manager. Now, however, I have another idea how to simplify, and better control future income streams. Still work to do and won’t be setting any of this up until later this year or into next year.

But I now have a further choice I am comfortable I understand that gives me greater options at a price of essentially low, but very defined, investment returns….. yes a Gilt ladder is not such a bad idea.

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