Should I switch some of my pension fund to cash as I approach retirement?

[Gordon Gekko]

That's a bit of a straw man.

Keeping a million in a retail bank account for decades would not be wise advice in any time or place.

How is it a ‘straw man’?

The industry classifies cash as ‘safe’ and equities as ‘risky’, when the reality is very different.

Lots of people do it in different ways, whether it’s too little risk in their pension fund or too much cash in the bank.

I spoke with my friend’s wife recently and her pension was far too ‘safe’. She’s in her mid 30s. Some fella from Mercer sat down with her for 10 mins and asked her whether she fancied high risk or low risk. She had no idea what those concepts meant, and like many people would answered “low risk”. She now has a significant six figure sum which is closer to cash than equities. That’s a far riskier approach in my view.

 

[Brendan Burgess]

The industry classifies cash as ‘safe’ and equities as ‘risky’, when the reality is very different.

Agree fully.

Brendan

 

[Sarenco]

…to the extent that withdrawals are covered by dividends the fall is of no relevance.

The stylised example referred to the total return on the portfolio from all sources - there is no additional source of return coming to the rescue in Year 1.

 

[Sarenco]

How is it a ‘straw man’?

It’s a straw man in the context of this thread because you are not simply concerned about the long term return on a portfolio once you are about to make withdrawals from that portfolio.

If the portfolio suffers a major drawdown in the early years of spending down the portfolio, your ability to benefit from any subsequent market recovery will be limited by the fact that you have already spent a portion of the portfolio. The sequence of returns matters.

 

[Marc]

Agree fully.

Brendan

except that these are two entirely different scenarios which are being mixed up to make a point.

someone in their mid 30s adding to a pension SHOULD have an equity bias. They have risk capacity and sequence of returns makes no difference.

Someone 5 years out from drawing their pension has an entirely different set of risks.

 

[NoRegretsCoyote]

How is it a ‘straw man’?

Because with a thirty-year investment horizon you would buy a thirty-year government bond. You would not leave it in retail deposits which almost always pay a lower interest rate. Your comparison was between equities and cash in the bank over 20-30 years.

The industry classifies cash as ‘safe’ and equities as ‘risky’, when the reality is very different.

These industry definitions are unfortunate simplifications but I expect a more financially literate discourse on AAM.

 

[Duke of Marmalade]

The stylised example referred to the total return on the portfolio from all sources - there is no additional source of return coming to the rescue in Year 1.

I'm obviously not explaining myself very well.
I am not questioning the math of your stylised example. I am not denying the existence of sequence risk.
I am challenging your apparent rejection of Colm Fagan's claim that using dividends to meet withdrawals mitigates sequence risks.
Let my try again.
If the 30% fall in equity values is due to the dividend yield going from 2.5% to 3.6% but with no change to prospective dividends then provided one is not selling the shares but simply pocketing the unchanged dividends the 30% fall is irrelevant.

 

[Gordon Gekko]

Because with a thirty-year investment horizon you would buy a thirty-year government bond. You would not leave it in retail deposits which almost always pay a lower interest rate. Your comparison was between equities and cash in the bank over 20-30 years.

These industry definitions are unfortunate simplifications but I expect a more financially literate discourse on AAM.

That’s the whole point. The person who buys the 30 year bond may get wiped out by inflation. What do you think happened to the patriotic rich Briton who bought a War Bond in 1945? Wiped out. What do you think will happen to the conservative pension investor who buys Eurozone goverment debt now yielding zero or negative? I think there’s more of a chance of being cleaned out by inflation than by investing in equities.

 

[Sarenco]

I am not questioning the math of your stylised example. I am not denying the existence of sequence risk.

Let me try again.

A dividend isn't "free money" - it comes off the share price. Say you bought a share in ACME plc on 1 January and it pays a dividend of €5 every quarter. If the share price is entirely unaffected by any factor other than the dividend payments for the entire year, the share price of ACME plc would be exactly €80 at year end.

Dividends are not interest payments. Interest is a return ON your principal; dividends are a return OF your principal. Interest compounds; dividends do not - unless you reinvest them.

Pocketing a dividend, rather than re-investing it, is exactly the same thing as selling a share of equal value to the dividend to achieve a return OF your principal.

In either case, you end up with a portfolio with a lower value than would otherwise be the case and you thereby limit the extent to which you would otherwise have benefitted from any subsequent returns on the portfolio if there had been no such withdrawals of principal.

That's what gives rise to sequence risk.

 

[Duke of Marmalade]

Sorry @Sarenco but that is so not right. Dividends are a pay-out from profits nothing to do with principal/interest etc. All things equal ACME’s price would be 100 at end year provided it earned those divies. Think property earning you rents. Rents are not a return of a piece of the property.
The first chapter on investments tells us that a share price is the market value of its future dividends from said profits (ignoring noise such as potential takeover).
So seeing that the price of a share is the value the market puts on its future dividends it can fall by 30% for the following reasons:
1. Future dividend prospects have fallen
2. The risks attaching to future dividends emerging have increased
3. The discount rate used to value the dividends has risen
4. Purely sentimental factors with no rational basis
For someone depending on dividends only (1) is of relevance. The other 3 are irrelevant (2 makes our investor a bit nervous). All 4 are of course relevant to someone who actually needs to sell the shares. A dividend is NOT the same as selling a share or getting a return of your principal.
Your example posits that the fund falls by 30% and then increases by 5% p.a. thereafter the same as it would have before the fall. This assumes that the reason for the fall is purely (1).
Here is the diagram:
Current price 100, dividends 5 so a 5% return
Price falls to 70, dividend stays at 5 and so return increases to 7.1%.
Your example has the return stay at 5% and so you have assumed that dividends have fallen by 30%

 

[Gordon Gekko]

It’s a straw man in the context of this thread because you are not simply concerned about the long term return on a portfolio once you are about to make withdrawals from that portfolio.

If the portfolio suffers a major drawdown in the early years of spending down the portfolio, your ability to benefit from any subsequent market recovery will be limited by the fact that you have already spent a portion of the portfolio. The sequence of returns matters.

I don’t disagree.

It’s why people who are reliant on a sum of money to last them the rest of their life should look at ideas such as:

- Keeping 3-5 years cash aside and living on that for 3-5 years without drawing on the invested portfolio
- Considering not taking the full ARF distribution in “down years” so only the deemed tax gets withdrawn
- Just keeping 4-6% of the value of the ARF in cash at all times so units/shares never need to be sold

 

[NoRegretsCoyote]

@Gordon Gekko

You are arguing against points I haven't made and are forgetting your original comparison which was a basket of equities compared to retail deposits. The latter would never make any sense for anyone with a decades-long investment horizon.

Otherwise you claimed:

What do you think happened to the patriotic rich Briton who bought a War Bond in 1945? Wiped out.

My understanding is that the average ‘real’ (i.e. after inflation) interest rate was around -1.5% per annum for the period 1945 to 1980. So wealthy people who thought that they were being sensible bought things like ‘War Bonds’ and saw their wealth destroyed by inflation.

You can look this up and find that real yields on 10-year UK bonds were about 0.2% 1945-1980.

It is (as you would expect) a miserable return compared to equities, but it is not a wipe out.

 

[Gordon Gekko]

It’s a wipeout

 

[NoRegretsCoyote]

It’s a wipeout

Sure, if you define a wipeout as a very slightly positive real yield over the period which would maintain the purchasing power of your investment.

Your previous threshold was a real yield of -1.5% pa which over 35 years is a loss of about 40%......

Edit: here is UK equities which in real terms lost a lot of value 1945-1980, much of this due to the high inflation of the 1970s.

 

[Sarenco]

Sorry @Sarenco but that is so not right.

So how do you explain the fact that the price of a dividend stock falls as soon as it goes ex-dividend?

The first chapter on investments tells us that a share price is the market value of its future dividends from said profits (ignoring noise such as potential takeover).

There is no expectation that Berkshire Hathaway will ever pay a dividend so how come its share price isn’t zero?

 

[Colm Fagan]

The discussion has moved on since my last contribution. However, I would like to pick up the thread on a few points.

There is nothing remotely artificial about sequence risk.

I agree that losses early during drawdown have more impact than if they happen later. My "artificial" point referred to the artificiality of the scenarios put forward by advocates of "sequence of return" or "pound-cost ravaging" risk, with specific reference to so-called 'studies' which assumed yearly withdrawals and no flexing of withdrawals, i.e. the ability to take less when times are tough, more in good times.
An equity portfolio can experience a severe loss at any time. It could be next month; it could be next year; we could get a few bad years together. I lost almost 3% in my first year of drawdown. My point is that, if I had decided to (say) invest 50% in bonds at the start, to address this risk, I would have been resigning myself to an extra 2% annual drag on the expected return on the portfolio (assuming a 4% equity risk premium: 50% of 4% = 2%). We would all jump up and down if we were told there was an extra 2% a year management charge on our portfolios. This is exactly the same; it's just expressed differently. For a 61-year old (which I was at the time I started the ARF), the possibility of suffering a 2% drag on performance for up to 30 years was far too high a price to pay to avoid the risk of a severe fall in the value of the investments every now and again.
In relation to dividends, once again, I don't disagree with the argument that a return is a return, whether it comes by way of dividend or capital gain. My point, as a practical investor, is that, to the best of my recollection, I have never had to redeem investments at the 'wrong' time in order to draw the obligatory 'income' from my ARF. The money for the 'income' has always been there when I needed it, either from dividends on stocks in my portfolio or from natural stock turnover, i.e. a particular stock falling out of favour. Of course, there is also the option of deferring taking an 'income' for a month or two, if needs be.
Finally, I don't deny that I have been lucky since I started the ARF at end 2010. When I started, I expected to be able to take a 6% income each year and to keep the original capital intact (on average). Things worked out worse than expected in the first year (when I lost close to 3%), but I more than made up for that loss in subsequent years, so that every €1,000 at the start is now worth close to €1,850, after taking an 'income' each year. If my a priori expectation had been realised, I would now be worth around €1,000, which is still far more than I could have expected if I had invested a substantial portion of my ARF in bonds at the start, withdrawing 6% a year.
I still hope to have a good number of years ahead of me, so I continue to invest close to 100% (bar a small liquidity float) in equities.

 

[NoRegretsCoyote]

Finally, I don't deny that I have been lucky since I started the ARF at end 2010. When I started, I expected to be able to take a 6% income each year and to keep the original capital intact (on average). Things worked out worse than expected in the first year, but I more than made up for that loss in subsequent years, so that every €1,000 at the start is now worth close to €1,850. If my a priori expectation had been realised, I would now be worth around €1,000,

I'm deliberately picking the worst 11-year period I can find, but between 1971 and 1982 and the S&P 500 lost about half of its value in inflation-adjusted terms.

If this had been your immediate experience after retirement, would you have persisted for the full 11 years with your original strategy of a 6% annual drawdown and full exposure to equities?

 

[Duke of Marmalade]

So how do you explain the fact that the price of a dividend stock falls as soon as it goes ex-dividend?

Because it has less cash. That was easy.
Let me recall from that text book the standard model of how our joint stock capitalist economy works.
A company is an organisation of capital and labour to sell goods or services to the community for which it receives turnover in the form of cash. So it builds up a pile of cash to handle. In the first place it will have to replace depreciating stock. Then it might want to expand the enterprise by further investment. Finally it has cash which it has no immediate use of and which would be better off in the hands of its investors. It pays this residual cash out in dividends. That is not in any way economically equivalent to a part sale of the enterprise.
Now the recipient may indeed wish to use the dividends to buy more stock in the second hand market, that is increasing her stake in the company. In your example a reinvesting holder of ACME stock would finish the year with 20% more share of ACME than she began.
I think you would understand it better in a property context. So take a rental property and just for more accurate analogy let it be held by a property company which manages the rents. Periodically the rents are distributed to the owners. This process naturally sees the worth of the holding company fall by the amount of the rents it distributes. But this is not equivalent to selling the properties by any stretch.

There is no expectation that Berkshire Hathaway will ever pay a dividend so how come its share price isn’t zero?

This is getting silly. I am not an expert on BH but the first few lines of Wiki tell me it is a holding company. So I am assuming it is somewhat like a fund. Funds don't pay dividends either. But on a look through we see that they are made up of the elementary text book examples of enterprises paying dividends. It's just that they have undertaken to reinvest these dividends for their owners rather than distribute them.
Please don't ask me to explain the Tesla share price or the dotcom share prices of old.

 

[Colm Fagan]

I'm deliberately picking the worst 11-year period I can find,

HI @Sarenco. I obviously can't put myself in the hypothetical situation you envisage, but I hope that I would always be guided by logic. And logic tells me that, by investing (say) 50% of my portfolio in bonds, I am sacrificing 2% a year in expected return. Do you not agree with that simple argument?

 

[NoRegretsCoyote]

And logic tells me that, by investing (say) 50% of my portfolio in bonds, I am sacrificing 2% a year in expected return

Of course. Over something like a 30-year horizon almost certainly equities will outperform bonds.

But for you: life expectancy of a 61-year-old male is about 22, and you have a desired withdrawal rate of 6% per annum. Therefore your investment horizon is a lot shorter than 30 years and a full equity allocation exposes you to sequence risk.

You've done great, and well done. But it's coincided with the best period for equities in a century. If you'd hit the worst period your strategy would have been a disaster.