How much of an ARF should be in equities?

Steven,

I will email you my own home made App (Excel spreadsheet). I wish I knew how to share it with AAM in general.
 
I've extricated myself from the arduous task of sunning myself in the garden in order to answer Bob's questions!

Bob2018 said:
I'm a bit confused by what you wrote here.
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I reckoned that the Duke's "clients" have relatively small pension pots and so couldn't incur the overhead associated with asking a stockbroker to set up an ARF for them. It is a long time since my ARF was set up, I don't recall the precise costs, but I doubt very much if it would be worth the associated overhead for a smaller pension pot.

My comment on the validity of the concept irrespective of size of pot was saying that, if fixed overheads were not a concern, the approach I've been adopting for the last 7 1/2 years with my ARF (and for the previous dozen or so years during the accumulation stage) will be equally applicable for smaller pension funds.

Bob2018 said:
can you also explain whether you are advocating a very small number of shares - again for normal people?
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I recognise that I am an outlier in terms of my approach to concentration risk, and I would not necessarily recommend a similar approach by others. I was simply telling what I have done. I started off 20 years or so ago by following a conventional approach, with a portfolio of 20 or 30 stocks. I eventually recognised that I just bought many of the stocks on a whim and decided to focus my attention on companies that I could be reasonably confident about, having researched them. I'm not a full-time investor, so have limited time for research. This obviously limits the number of stocks in the portfolio. The relative performance of my portfolio has improved significantly since then.

As an aside, I think much the same is true of professional portfolio managers. I recall reading a report somewhere that the good performance of high performing portfolios is concentrated in about five or six stocks, and that the rest are basically fillers. I also recall attending an investment conference a few years ago at which the manager of a particular portfolio said that stocks the managers classified as "winners" accounted for 20% of the portfolio. He didn't have a satisfactory answer when I asked why "winning" stocks it didn't account for 100% of the portfolio.

Comparing my approach to investing with that of the amateur investors who have decided to eschew the rarefied world of insurance companies, investment advisers, et cetera in favour of doing their own thing by buying a few houses or apartments for investment purposes, they would be more than happy with a portfolio of eight apartments, rented out to different customer types in different cities across the world. That's how I look at the portfolio of a small number of different companies’ shares in my ARF. The biggest investments are in companies that I am confident will stand the test of time: they have sound balance sheets; projected dividends and profits are such that I expect to get a good return even if I never decide to sell; they are unlikely to be driven out of business by Amazon, Facebook, or whoever.

I’m not pushed if I don’t beat the index; all I want is the risk-free rate plus 4% to 6% in the long-term. I’m happy that my portfolio will deliver that long-term return. I invest smaller amounts in shares that I think will deliver, but which I’m not yet certain about. In time, as I get more familiar with the company, I may decide to increase my holding.

Bob2018 said:
can you also explain why there is no need to be concerned "sequence of returns" risk?
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“Sequence of returns” risk is only a cause for concern if it is necessary to sell stocks when they’re down. Obviously, falls in market values concern me as much as they do anyone else, but I have a very low turnover rate on my portfolio and, as I indicated in my previous post, I don't ever recall having had to sell a stock in order to meet the "income" requirement (because of dividend receipts, cash balances in the portfolio, etc.). Back to my earlier analogy of an amateur investor who has a portfolio of apartments, I just throw the notes from the estate agents into the bin if I don't like the prices they are offering for the apartments at any particular time.


Bob2018 said:
And how realistically could a "normal" person no good stocks to pick when professional managers have a hard time beating benchmark returns in the long haul?
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As I said earlier, I have no particular desire to beat benchmarks; all I want is to earn a real return of 4% to 6% per annum. Experience over many years has shown that an average portfolio would have achieved that objective. As it happens, my long-term track record compares well with that of professional managers but I recognise that most of my long-term success can be attributed to one company that I was lucky to discover 20 years ago and which I have stuck with since then.
 
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And there is the secret to your success. You know what you want and you are not bothered by all the noise that goes on around you. You have holdings in companies you are confident in and leave it at that. A bit of luck always helps of course!

Investors chopping and changing investment strategy all the time costs money. Pick quality from the outset and stick with it. Too many people and especially advisors feel they have to change their investment strategy all the time. It doesn't work.

It'll be interesting to see how all these risk adjusted funds the life companies have out will perform in the next real downturn. They all reduce equity exposure when volatility increases and move back when it's more settled. Sounds like market timing to me and if they are all using the same metrics, the movements should be the same amongst all the life companies. I have a feeling we'll see very different results.


Steven
http://www.bluewaterfp.ie (www.bluewaterfp.ie)
 
Thanks to Colm for explaining his position. I think thanks are also due Elacsaplau for setting out this whole question so well and to SBarrett who explained brilliantly the real human aspects of all this.

I don't think Colm's approach is for me. My fund size would not be big enough and I would not be able to decide which stocks to buy. I suspect that I will not be alone in this view. The entire elderly population are not going to become mini-investment managers when they hit retirement. It's just not a solution for the "normal" person.

Even Colm, who is obviously an expert, recognises that he was lucky ("most of my long-term success can be attributed to one company") and I'd prefer not to overly depend on luck with my retirement money. It seems to me that when someone with lots of skill says that he was lucky, there's much less chance for the ordinary man. I'm the "normal" guy (unlike Protocol's lucky parents) and I will need the money! I also don't want to overly think about this stuff when I am retired and I know that having all my money invested in shares would cause anxiety for me, not to mention the missus (the boss). I agree with SBarrett when he says that one should just have a long-term strategy and stick with it. Another problem, I see with Colm's approach is that even for experts like Colm, one's capacity to act might reduce with age. Not alone would I not have a clue now of the right stocks to buy and sell but I'd imagine I'd have even less of a clue if I'm still above ground 20 years for now. Also, my beautiful wife would have zero interest in any of this stuff.

So whatever my level of equities will be, it is likely to be invested in some fund. If all my ARF is invested in equities, it would mean that I would have to sell units to pay for withdrawals and that as a result I would be subject to sequence of risk if I am understanding this correctly. Can readers advise whether this understanding is true or not please?

Putting all my money in equities is out and just wouldn't make any sense for me. What seems much more sensible to me is that I put somewhere between 60% to 80% of my money in an equity fund. In this way, I'd have effectively 5 to 10 years in safer assets and I wouldn't have sell my equities when markets are bad as I'd be able to allow my equities sufficient time to bounce back. I know I could still get hurt if Japan-like event happens but I'm trying to find the happy medium.

What I've written just above is a real layman's view. What I'd like is for advisers to show how they can improve on this (setting out whatever assumptions or caveats that they need to). As my old man used to say, there's no point in having a guard dog and doing the barking yourself.
We need advisers to guide us through this maze by showing us realistic sample solutions to these questions.
 
Bob

The unit linked/ fund ARF operates under the gross roll up method, so any dividends or profits are reinvested into the fund. Colm has a self directed ARF with individual stocks where the dividends are paid out and sit in cash. So yes, any withdrawal from a unit linked ARF will mean the sale of units. That will be the case whether you are invested in a cash fund or an equity fund, they are all unit linked.

Different life companies have different methods in deducting income from ARFs. Some will accept instructions that your withdrawals come solely from your cash fund and to leave the equity portion alone. Others will split the withdrawal evenly amongst your different funds.


Steven
http://www.bluewaterfp.ie (www.bluewaterfp.ie)
 
Thanks Steven,

So just so I'm sure that I've got it. If all my money was invested in equities, I would be exposed to a sequence of return risk?
 
Aren't you always exposed to sequence risk in any asset class? And any unit linked fund has always had the management charge taken from the fund by deduction of units.

Good article here on sequence risk which I've linked to before.


Steven
http://www.bluewaterfp.ie (www.bluewaterfp.ie)
 
Hi Steven,

I'm just trying to get a straight answer to a straight question. I feel I'm just going around in circles with you financiers! I asked Colm this question yesterday and he said in his answer today that he personally wasn't worried this risk because of the make-up of his fund. The reason that I had asked that question is because earlier in the thread when Gordon Gekko mentioned sequence of return risk at a general level - Colm dismissed this as making "no sense whatsoever". To be honest, I'm still not really sure what Colm is saying here and since he obviously really knows his stuff, I'm confused and that's the reason that I was hoping for confirmation one way or the other.
 
Yes, you would be exposed to sequence risk. But studies have shown that sequence risk shouldn't be a factor.

If you have €1m in an ARF and take out €40,000 a year. The higher expected return you get from being wholly invested in the market will more than cancel out the lows and still allow you to take out €40k a year. You will be no better off by investing a portion in equities and the rest in bonds/ cash and exhausting that asset class before spending your equity portion (see the table in that link for examples under different scenarios).


Steven
http://www.bluewaterfp.ie (www.bluewaterfp.ie)
 
Bob has asked some good questions and made some interesting comments. I'll try to deal with them to the best of my ability, whilst qualifying my answers by stating that I am not an adviser.
Bob2018 said:
Even Colm, who is obviously an expert, recognises that he was lucky ("most of my long-term success can be attributed to one company") and I'd prefer not to overly depend on luck with my retirement money.
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I was lucky in being able to outperform the selected benchmarks. By just investing in the index, I would have still beaten my target return of risk-free plus 4% to 6% over the long term. That option is available to anyone - if they're prepared to accept the associated volatility. I have proposed a solution to the volatility problem, by smoothing returns over a long period.
Bob, you make a valid point when you mention the concern about what might happen as I get older and/or depart completely from this life. I do think about it occasionally, especially as my dearest and dearest doesn't have a clue about investments and doesn't want to learn. I hope that the stocks I've picked for my ARF will do well in the longer term whether I'm around to monitor them or not. In that regard, I was very encouraged by a posting on this forum (by Sarenco, I think) which referred to a "Sloth Fund". This fund (I think it is an actual fund) is invested in the top stocks from 50 years ago, with no active changes in the investment mix since then. This fund's performance has matched (or possibly even done better than) the S&P index over the entire period. I'm hoping that the same could be true for my fund. I have of course made other contingency plans in that I'm giving enduring power of attorney to someone whose judgement I trust, to be invoked if I go ga-ga (some on this forum will claim that I already have!).
You're also correct, Bob, in that someone who is invested in a unit fund will have to cash units to meet income requirements in retirement. That exposes them to the sequence of return risk. They won't have the option that's available to me of taking the income (or the vast bulk of it) from dividends, from assets being turned over within the fund, and from the cash content of the fund. There is a simple solution: insurers and fund managers could offer funds that distribute income rather than reinvest it to buy more units. Such funds would primarily be aimed at ARF holders. At the risk of repeating myself for the nth time, my "smoothed fund" proposal also deals with the problem.
Bob2018 said:
What seems much more sensible to me is that I put somewhere between 60% to 80% of my money in an equity fund.
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Of course, putting (say) 40% in bonds reduces the short-term volatility of returns, but it also reduces the expected return by about 1.5% a year (assuming that equities are expected to generate a return of almost 4% per annum more than bonds). That's a lot of money. I don't know about you, but I don't fancy throwing away 1.5% of EXPECTED return every single year. And for what are you prepared to sacrifice that return? For lower short-term volatility, I presume. And why should short-term volatility matter to you if your expected investment horizon (even at my age) is still over 20 years?
Bob2018 said:
earlier in the thread when Gordon Gekko mentioned sequence of return risk at a general level - Colm dismissed this as making "no sense whatsoever".
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What I dismissed as "making no sense whatsoever" was Gordon Gekko's suggestion that you should keep 15 years' of residual expenses in cash if you were going to be receiving regular rental income from apartments (or dividends from stocks). Why would you keep so much cash rotting in deposit accounts (or nearly as bad, in low-yielding bonds) if you're getting a nice steady income from the rentals/ dividends?
 
I want to give my tuppence worth on sequence of return risk. This arises precisely because you plan to sell equities. So let us take a 65 year old considering the investment of his ARF. He wants to maximise his expenditure on this side of veil. He reckons 30 years should do. He also reckons that equities will earn 6% p.a. over that 30 years. After contacting his local actuary he is told that using an annuity rate at 6% p.a. he can afford to withdraw 7.3% p.a. The problem is that if after 15 years equities have earned only 1% p.a. he is in the poor house. After 15 more years in the poor house he gets the double whammy that he was right after all, equities did grow by 6% p.a. for 30 years.

If he gets off to a bad start there is no real strategy for avoiding this risk. In fact let's say equities fall 20% in the first year, a phone call to that actuary friend will tell him that he must now cut his budget by 20% if he still believes that equities will earn 6% p.a.

Sequence of return risk does not arise in Colm's case because he is not budgeting to spend all his ARF before departing this mortal coil. But for Mr. Normal it will be necessary to plan for exhausting his ARF if he is to maximise standard of living. Going for a more balanced investment approach will indeed mean expected future returns will be less than on equities and the budget must be adjusted accordingly but there will be a much reduced sequence of return risk.

So I am not at all sure that Mr. Normal should have 100% of the ARF in equities. For sure he can expect it to be the best performer over the long term but the problem is that he can't spend that premium without exposing himself to serious sequence of return risk.
 
Colm,

Thank you! Thank you sincerely. I very much appreciate your time. Of course, thanks to me, you won't have got sunburnt!

As you were so fair in your comments and in the interests of good debate, I will just shoot from the hip with my honest thoughts about the parts of what you have said that I might "wonder about". Maybe these are a bit silly but at the same time they may provide insights into what Joseph Soap thinks about this ARF puzzle and in this way help you communicate your ARF proposals to the masses.

1. Recent performance is just that and it can change for better or for worse ( 7 or 8 years does not seem that long to me). I'd actually prefer to be retiring if the last 7 years had dismal returns if that makes sense!

2. Your group ARF proposals sound great and you are to be applauded for them. I'm sorry that I am unaware of what their current status is and when they will be available. I am also not sure whether I will have access to them as I thought you mentioned having employers involved -
which doesn't apply to me. So it might be best to focus this thread on the right approach at an individual level.

3. "Equity investment is available to everyone if they are prepared to accept the associated volatility". I did eventually find a good adviser recently. One thing that he said that struck me was that a person needs to be "willing, able and need" to take on a certain level of risk. It seems to me that the acceptance of volatility only considers the "willing" part of this triangle and SBarrett addressed the total requirements very well.

4. You are clearly far more qualified than me to evaluate the merits of funds distributing dividends. Will it really make a material difference? In any event, like the group ARF proposals, it's probably best to deal with what is available to invest in now rather than what might be available. It's a bit like I read somewhere that buying a pension now that only pays out later (say at age 80) could be a useful tool but this option is also not available in Ireland but does exist in other countries I think.

5. I don't fancy throwing away 1.5% a year! But I don't fancy a Japanese style meltdown either. And if that happens, it is not a short-term volatility issue. Put it like this, the extra 1.5% a year means when I go to the restaurant, I wouldn't have to ask for a bottle of the house red, I could go down the list a bit. If Japan happens, not alone will the wine be replaced by tap water but the visit to the restaurant would be at risk. This adviser asked me an interesting question: what would you prefer to have: 100% of your needs or risk 25% of your needs to achieve 100% of your wants? That's the real dilemma for the "normal" guy and all I'm trying to do is to get a sensible balance. As I said earlier, I want to be relaxed and not anxious about my income in retirement.

Let me finish with a small quibble. I think Sarenco was the 15 year in cash man and I think that I quoted accurately your reaction to what Gordon said! No big deal.


Duke,

I get most of what your saying but my head is now completely fried. I remember being told once (by a good friend) "normally I say there's no such thing as a stupid question but honestly, Bob, there are times when you come very close." So apologies in advance but I'm struggling with the bit quoted below:

Duke of Marmalade said:
After contacting his local actuary he is told that using an annuity rate at 6% p.a. he can afford to withdraw 7.3% p.a.
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Tell me this is a typo PLEASE!
 
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Hi Colm,

Point of Information if I may; I never said that!

When I get to your stage, my ARF will be 100% invested in equities.

All the best,

Gordon
 
Gordon
Sincerest apologies. In my original posting, I correctly attributed that comment to Sarenco. Also, in fairness to Sarenco, I qualified my "making no sense" comment by putting it in the context of someone having their money in eight apartments rented out (or eight shares producing dividends).

Bob
It was the 15-year cash proposal that I said made no sense, not what Gordon said. Gordon mentioned the sequence of return risk, which I accept is very real if the only investment option is accumulation only funds.

I agree that the last few years have been good for my portfolio, but my estimate of 4% to 6% per annum over bonds has been achieved by the average market participant over very long periods, and expert opinion is that the prospective Equity Risk Premium is still in that range. Therefore, if I were an adviser, I would be advising someone to put the maximum possible into real assets (including equities, property, similar). We've had the discussion previously about what the "maximum possible" means.
The "willing, able and need" to take a certain level of risk is an interesting thought. The Duke expanded on this aspect in a previous post, when he made the point that, if you need to get (say) 10% on your savings, then you have to put the money into emerging equities. I can make a similar argument at the other end of the risk spectrum. Thankfully, I don't "need" to take risks. We have a nice home that's fully paid off; we have other investments, in addition to my ARF (but I don't have any DB pension entitlement). I could survive by putting my money into a "safe" asset such as an annuity or bonds, but I can afford to take the risk, which (so far) has enabled me to enjoy a more comfortable lifestyle than I might have otherwise. If things go badly, we will have to trim our expenditure somewhat, but so what? We can afford to cut back if necessary.
By the way, I don't think the Duke's comment about 6% and 7% was a typo. What he means (I think) is that, if interest rates are 6%, then the annuity payout could be 7.3% a year.
 
Hi Colm,

I’m slightly confused; say I’ve a €2m ARF; I’m compelled to take 6% out per year which I’m not going to get by way of income yield on the portfolio. So surely I will be disposing of shares in order to meet my mandatory distribution, making weak markets a problem for me in the context of sequencing of returns.

Or am I missing something?

Many thanks.

Gordon
 
Gordon, the missing link is that I'm allowing for a (low) level of turnover on the portfolio. I reckon that my turnover rate is much lower than average, but yet I make a few changes a year to the distribution of my ARF portfolio. Sometimes it amounts to little more than trimming at the edges: reducing my exposure to one share by a few percentage points and increasing my exposure to another one by a few points; at other times it's more radical: I may decide to get out of one share completely (as happened recently with WPP, which was featured in my "Diary of a Private Investor"). Those adjustments to the portfolio can be used to generate more cash. Remember too that only a small amount extra will be required. The current dividend yield on the FTSE All-Share Index (which is my main benchmark) is 3.8%, so only another 1.2% is needed to produce 6% (OK, we have to allow for costs, but I have managed to keep them to a minimum).
 
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