An alternative approach to decumulation

Taking up on Sovereign Quest’s challenge here is my contribution.

In the discussion about attaining financial independence and retiring early (“FIRE”) there is an accumulation phase and a decumulation phase. In the first phase you accumulate assets by earning, saving and investing in order to have enough assets to be financially independent. This is followed, sooner or later, by the second phase when you spend, or decumulate, your assets in order to fund your retirement. The objective in this second phase being to make your money or assets last for as long as you, and any dependant family, live.

I have looked at the ONS life expectancy tool. Using only age and sex this tool suggests that on average my wife and I will reach our mid-eighties. It also suggests, however, that there is an 11.19% probability that at one or both of us will attain one hundred years of age. I left work behind in my early fifties so, rounding up, I am looking at a fifty-year decumulation phase.

Some early research on decumulation by an American financial adviser, Bill Bengen, in the 1990’s, suggested that there was a safe withdrawal rate (“SWR”) of 4% per annum. Using an equity and bond portfolio and based on all previous thirty-year periods, you could withdraw 4% of the opening assets in the first year and increase that amount for inflation each year, and have some assets remaining after thirty years. This was a historical model based on past performance. I regard it as a useful rule of thumb, or an estimate of what might happen, rather than an absolute truth.

My alternative approach is not to decumulate my assets but rather to use those assets to generate an income to fund my life after leaving work. I currently aim to maintain the real value of my assets. I have followed this approach for just over seven years. One aim of my approach is that my capital assets keep pace with inflation. On my last review they had fallen 3.09% behind inflation. I am hopeful that will reverse in future. I also track my investment portfolio income and my expenditure against the 4% “safe withdrawal rate”. So far, my expenditure, or withdrawal rate, has been below the SWR, whilst my income has been higher than the SWR for the last four years. This is encouraging.

Historically a significant risk in decumulation is a bad sequence of returns in the first few years. I calculate that real returns, after inflation, for a UK investor have been under 2% per annum over the last seven years. This compares poorly to longer term historic real returns of over 5% per annum. I believe these poor returns so far have not undermined my approach.

In considering the longer-term viability of my non decumulation approach I have studied the historic past performance of certain investment trusts that are included in my portfolio or are representative of my portfolio. Certain of these investment trusts have existed for between fifty and one hundred and fifty years, and historic records for some can be traced back as far as the 1960’s and 1970’s. A key issue is whether the dividends that were paid out in the 1970’s kept pace with the high retail price inflation of that time. I follow the so-called dividend heroes and next generation dividend hero trusts and hold some of them. Although they have increased their dividends for many years, it is important to understand whether such increases exceeded the inflation rate.

I considered the fifty-year history of five investment trusts from 1970 to 2020 using their published accounts. The net dividend yields for these five averaged only 2.26% back in 1970 so you would then have needed capital assets of 44.15 times your income requirement. (This compares to a 2020 average yield of 5.74% and 17.43 times your income requirement.)

I calculated the results of a withdrawal process of taking the initial dividend in 1970 as the first-year withdrawal, then increasing that for inflation each year. Looking at the actual annual dividend increases compared to annual retail price index increases for the fifty years, on average there were fourteen years when the dividend increases were below inflation. This meant that on average there were seven years when actual dividends were lower than these targeted withdrawals. The low points in the worst years ranged from 97.88% to 63.70% of the target. The average of these worst years was 84.80%. This suggests that you may need to contemplate an effective dividend pay cut of close to 20%.

For these five trusts I also calculated a safe withdrawal rate that would have enabled the closing capital in 2020 to maintain the real value of the opening capital in 1970. These gave an average of 3.46% and ranged from 2.70% to 4.80%. This average is 1.20% higher than the opening dividend yields. This suggests that some capital could have been drawn down in addition to the dividends in payment.

The most challenging period was between 1970 and 1982. Inflation exceeded 7% in every year and peaked above 24% in 1975. In this period compound inflation growth was 13.10% per annum. This was higher than dividend growth, higher than capital growth, and more than double capital growth net of withdrawals.

My modelling of these historic results highlighted the variable results of my selections. Also, there must be a survivorship bias because I have selected survivors. This analysis of a fifty-year withdrawal period is incredibly sensitive to small changes. Increasing these withdrawal rates by 0.5% would have caused all these investments to fail with their capital balances running down to nil. Only two of the five would have survived a 4% withdrawal rate.

A key point I will deploy is to be flexible in my spending and in my investing. If in future inflation runs ahead of dividend increases then I may need to take a pay cut rather than sell assets and reduce my capital. If an investment I hold becomes no longer committed to increasing or at least maintaining the dividend then I should probably sell it and buy an alternative.

Conclusion

This analysis has shown up some uncomfortable historic truths that would have challenged my approach during the last fifty years. It’s useful to know this but I’m not minded to change my approach at present. I will remain vigilant in reviewing the situation and be ready to be flexible in my responses.

Reference

	NDY (1970)	Div incr < RPI	Div < Wdl	Low point	SWR calc
	%	No. of years	No. of years	Div as % of Wdl	%
CTY	2.70	11	5	94.55	3.90
MRCH	2.30	21	14	78.37	2.90
LWI	2.71	9	5	89.53	4.80
MYI	1.98	13	11	63.70	3.00
HFEL	1.64	14	2	97.88	2.70
Average	2.26	14	7	84.80	3.46

1970 to 1982	CAGR	CAGR	Capital growth
	Capital	Div	after SWR Wdl
CTY	7.81	11.90	4.99
MRCH	7.54	10.07	5.07
LWI	10.02	13.41	4.22
MYI	9.51	8.44	5.97
HFEL	8.00	12.48	6.05
Average	8.58	11.26	5.26

RPI 13.10

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