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Hallowed publications, sage journalists, amateur investors
Huffing and puffing: beating inflation by using the right filter.

Hallowed publications, sage journalists, amateur investors

Every now and then we offer to write some content for financial papers, magazines or websites, and every now and then they say ‘yes’. The IC is a virtual bible for DIY investors and we were recently asked to comment on and critique one reader’s portfolio and planning – he was seeking ideas and reassurance as he steps confidently to his impending retirement. Hold this picture, I’ll come back to it.

First I want to outline for you that every person who seeks advice with us, and who becomes a client, goes through a planning exercise. There are various reasons for this, all centred around creating a roadmap that both we and the clients agree on, can follow and can use to measure progress in coming months and years.

There’s no way round this exercise (unless you’re a charity we’re working with), as without it the investor expectations are always flawed, and often quite wrong. The planning exercise allows the client to construct and agree planned expenses for the initial years: for the last 30-40 years we have spent our financial lives being guided by the salaries/earnings we have, and we fit the expenditure within that monthly sum. Now in retirement many folk start at the wrong end of this P&L account – and unfortunately with invested income that is not a fixed monthly sum, so starting with ‘What income can I get?’ should always lead to disappointment.

I say ‘should’ because any adviser worthy of your time must err on the side of income caution. The correct question for pension preparation is ‘What income do I need?’; it is only once that is worked out that the planner can then build the relevant and reliable income plan.

Which takes us back to the Investors’ Chronicle, let’s call the reader Bill: in the case study Bill said he was concerned about running out of money when retired and if he’d have enough income. His kids are financially independent (Ed: hah!), he has two £6k pa final salary schemes, various pots, and wants to live on £40k per year. This is summary P&L:

We calculated the annuity for him and slipped it in – you can see from this simple table that by using his existing cash pensions to buy an annuity (RPI linked); he achieves his pension objective straightaway, he guarantees the money will never run out and he will never have to worry when retired about markets, crashes, inflation etc, and it leaves his cash and ISA untouched, free for him to spend or gift as he wishes.

This is what planning does; Bill probably prefers having his pensions invested so he can leave his money to his kids/grandkids, but he might want to have an annuity that covers his £25k basic expenses, and, most importantly, he now has a base line of income security that he knows will always be available to him. This is the start of the planning conversation, it’s the start of pension planning.

Huffing and puffing: beating inflation by using the right filter.

Inflation can blow things over, and a yacht in a storm will get battered by the wind it depends on to get anywhere. Any sailors reading this know that storms like the one below tend to be gusty, and although a peak gust can hit a frightening 100 mph (the record is storm Eunice at 122mph) the average speed over a day will be much, much less, and over a week it’ll probably be negligible.

Inflation has proved to be the same: if you are retiring now, don’t try and fix investment income to deal with the 11% inflation that we saw last year – that is unrealistic and unnecessary. When the yacht above gets slammed, it drops its sails, flies a storm jib, literally closes the hatches, perhaps drags an anchor, and waits it out. As an investor, your equivalent when faced with an inflation spike is to spend less, consume less, put on a jumper, drive less, make more home-made soup and wait it out. Storms and inflation are cyclical, they are not permanent.

When looking at income we use 5-year rolling averages, we don’t use single year figures. When looking at growing a client’s pension income we seek to construct a portfolio that has demonstrated resilience over the rolling 5 years, versus RPI measured the same way.

The results are very reassuring: starting in 1986, 5 year rolling RPI has never beaten 5 year rolling dividend increases from our trust selection – not once.

The two charts below show you firstly the difference between looking at 32 individual years (discrete years) of divi v RPI, and secondly the same data but showing the 32 periods of 5 year rolling growth v RPI. The latter is much smoother, much more reassuring, so unless you’re only intending to retire for just one year, please, don’t use single year figures in your planning.

Single year RPI vs dividend growth - 32 years: