The Two Phases of Wealth Building

Every week I religiously capture the value of each of my investments which I then sum to give me an instantaneous net worth.  This week saw my net worth increase by more than £5,000 without contributing any new money.  For me that is a very large amount of money, and of course Mr Market could take that £5,000 away this week, but it reminded me of the two phases of wealth building that I'm seeing as I'm working to build wealth over a quite short period of time.

The first phase is Building Capital.  As you start on your wealth building journey this is the first phase you pass through.  Here you just want to be adding as much capital to your wealth as quickly as you can get your hands on it.  Saving Hard by Earning More and/or Spending Less will have a much bigger effect in this phase than Investing Wisely.

The second phase is Return on Capital.  Here while Building Capital is still providing a big boost to your wealth it’s now more important to have a stable investment strategy which is very tax and investment expense efficient.  In this phase you could even start to ease of the Saving Hard by for example going part time or taking up that lower paid higher enjoyment opportunity you’ve always desired without moving your financial independence day greatly.

Let me demonstrate the two phases with a simple example (where I’ll ignore inflation) that tries to cover many of the points that I personally live (and have lived) as well as regularly capture on this site.  Average Joe works hard and for his hard work receives £45,000 per year making him a 40% higher rate taxpayer.  Joe wants early financial independence to give the option of early retirement and so starts to think about he might achieve that.  He realises he firstly needs to focus on Building Capital by Saving Hard.  His employer offers a pension scheme where if Joe salary sacrifices 5% of his own salary then they will match it.  There’s some free money there so he goes for it.  Salary sacrificing also brings the benefit of lowering Joe’s taxable salary to £42,750 saving both employee and employer National Insurance.  Joe’s employee NI saved is added immediately to his pension but his employer also generously adds the 13.8% employer NI that they also save.

A Significant Milestone

Noel Whittaker in his book Making Money Made Simple states that in a country such as the UK (he actually cites Australia as an example) “the average person needs only two things to become wealthy – the knowledge of what to do, and the discipline to practise the things that need to be done.”  When put that way it sounds so simple (and of course it is) however reality is of course a different story all together particularly when I look back at my own potted history.

I graduated and started work in 1995.  Almost instantaneously I took on plenty of debt in the form of a car loan and was quick to ramp my standard of living by spending nearly everything I earned (I did save a small amount into an employer pension but it was nothing more than the default fund).  It actually took me until 2002 to make a small purchase into my first investment fund which was not part of any overall strategy but simply a random purchase.  I can’t even remember what prompted the purchase but it certainly wasn’t the “knowledge of what to do”.   It was a great selection [sic] with annual expenses of 1.78% along with a 4% contribution fee.  Hardly the road to wealth.

It actually took me until 2007 to wake up and start to figure out what the game was all about which is when my wealth building journey to financial independence really started.  It was in this same year I bought my first tracker - a FTSE All Share Tracker Fund.  That is 12 years from when I started earning a full time salary to even begin to have the personal finance “knowledge of what to do”.

The RIT High Yield Portfolio (HYP) – Adding GlaxoSmithKline

I’ve now been building my High Yield Portfolio since November 2011.  A reminder of my previous purchases:

• On the 28 November 2011 I purchased AstraZeneca (LSE ticker: AZN), Sainsbury’s (LSE ticker: SBRY) and SSE (LSE ticker: SSE).
• On the 21 December 2012 I added Vodafone (LSE ticker: VOD).  To avoid all the Verizon Wireless disposal fun and games I subsequently sold out on the 21 January 2014 and then repurchased the new VOD on the 30 April 2014.
• On the 11 October 2013 I received 227 shares as part of the Royal Mail Group IPO (LSE ticker: RMG).  I didn’t consider it a HYP purchase at the time (and still don’t) but simply the closest thing to free money I’ve come across in a long time.  The tax payer really was fleeced on that one.  It sits within my HYP as it is the closest match within the different portions of my portfolio.
• On the 03 March 2014 I then added HSBC (LSE ticker: HSBA)
• On the 30 June 2014 I added Pearson (LSE ticker: PSON) and Royal Dutch Shell (LSE ticker: RDSB).

The experience continues to be positive with the HYP as of Friday (excluding the GSK purchase) sitting on a trailing dividend yield of 4.6% compared to the FTSE 100 dividend yield of 3.3%.  At the same time the HYP is also outperforming the FTSE 100 from a capital growth perspective.  Year to date capital growth of the HYP is down 0.6% compared to the FTSE 100 which is down 1.0%.  Since inception the HYP has grown 35.4% compared to the FTSE 100’s 25.7%.

Wealth Warning: I don’t know if long term this HYP strategy will work.  There is every chance that a simple diversified portfolio of lowest expense index trackers that are invested tax effectively will in the long term outperform this strategy.  Only time will tell. 

Buying GlaxoSmithKline

So with hundreds of shares to choose from I grabbed GSK on Friday.  Let’s review why by sharing my usual selection criteria.  At the same time let’s also have a quick look at how HYP’able my current holdings also look today.

1. Is the business model simple to understand?

The first criteria is qualitative.  I want to understand how the business I’m buying makes its revenues in less than 10 seconds.  GSK and its brands hardly need an introduction.  They are a global pharmaceutical and healthcare company developing and supplying medicines to help people do more, feel better and live longer.  They make everything from Ventolin which any asthma sufferer will likely know well, through remedies such as Beechams Cold & Flu and onwards to day to day brands such as Macleans toothpaste.  They even own the Horlicks brand.  This is simple to explain and understand so meets my first criteria.

Freedom and Choice in UK Pensions : It’s Not All Good News for Responsible UK Personal Pension Holders

As part of the UK Budget 2014 George Osborne briefly announced the next tranche of government pension tinkering.  More detail in the form of the fifty page document entitled Freedom and choice in pensions : government response to the consultation has just been published so let’s briefly look at what I think is the good, the bad and the ugly as far as I'm concerned.

The Good

The Budget included the announcement that from April 2015 pension holders would get unrestricted access to their personal pension savings.  The mainstream media became all excited and started talking about people cashing in the lot and buying Lamborghini’s.  I ignored this nonsense and thought it actually might give responsible people (like myself?) who are saving for their future an intangible benefit so have been keenly waiting for the detail.

I currently have 44% of my wealth tied up in Pension Wrappers as they have the potential to (I say ‘have the potential to’ and not ‘will’ as once you’re in it’s difficult to get out again without punitive taxes and governments are guaranteed to continue to tinker) give me a healthy reduction in tax over my lifetime.  This comes from a few areas:

• As a Higher Rate taxpayer while working but expecting to be a Basic Rate taxpayer in retirement I’m avoiding 40% tax now in exchange for 20% tax as I start to withdraw from my pension.
• By salary sacrificing I’m also getting the employee national insurance that would have been paid on the sacrificed amount added into my pension as well as the majority of the 13.8% my employer saves by not having to pay employers national insurance on the scarified amount.
• Being able to take a 25% tax free lump sum at retirement. 

Best UK Savings Account Interest Rates & The RateSetter Experiment

I have been using Yorkshire Building Society (YBS) as my Savings Account provider for a few years now.  While once at the top of the best buy league they haven’t been there for some time now.  They have however always been pretty close from an interest rate perspective and have been no nonsense from a T&C’s perspective.  I was receiving 1.5% AER meaning as Higher Rate Tax payer and with inflation running at 2.6% I was receiving a Real interest rate of -1.7%.  In other words every pound sitting in YBS was being devalued monthly.

Recently, they have sent me a letter which starts out with “As your building society, you'll know that we have a tradition of looking after all our customers with good value products and great service...” Great start but of course the small print advised that they were further reducing my savings account interest rate to 1.25% AER.

Of course I’m not surprised given the latest average savings account data from the Bank of England shown in the chart below which show instant access savings rates down 0.27% in the last year.

Click to enlarge

Going to the market for the latest best buy savings accounts reveals very little.  Moneysavingexpert.com recommends the Santander 123 current account which has sliding scale interest rates (between 0% and 3% AER), a monthly fee and minimum deposit requirements.  The best clean rate looks to be Britannia or Coventry BS with a 1.4% interest rate but these accounts can’t be run online.

A Retirement Investing Today Review 6 Months into 2014

The June distribution laggards have now paid up so let’s take a pause to validate whether the tools and techniques from this site actually work in the real world.  This is achieved by my living the Save Hard, Invest Wisely, Retire Early mantra.  I'm a real life guinea pig putting my own money where my mouth is.  A mistake in one of my concepts could affect not only me but also my family greatly.

SAVE HARD

It’s now my sixth year of aiming to save 60% of my earnings, where earnings are defined as my gross (ie before tax) earnings plus any employee pension contributions.  Changes over the past six months mean that this target is now out of reach and a revision to a 55% target is needed.  Before you start flaming me I confirm that I haven’t been a hypocrite and started a consumerist lifestyle.  Instead the change has been caused by a healthy salary increase which is taxed at the 40% Higher Rate plus 2% National Insurance making 58% the most I could save from this new money.  Additionally, to keep my better half and I on the same financial independence trajectory this increase means I now need to cover all of the household costs as well as direct some of my savings to my better half’s investment portfolio.

In addition this half year saw HM Revenue and Customs change tune and make some aggressive demands for a tax error that they made in the 2012/13 tax year which enabled me to regularly save in the high sixties/low seventies.

Click to enlarge

Saving hard first half score: Conceded Pass.  Without the HMRC recovery, which I’d already saved in previous periods, the savings rate would have been held.  Since sorting this the new 55% savings rate has been sustained.

A Sobering Income Drawdown Demonstration One Year On

When we left our UK Invested Income Drawdown dependent Retiree’s a year ago there was trouble afoot.  Our 4% Withdrawal Rate Retiree, which remember is the Safe Withdrawal Rate (SWR) Rule of Thumb many talk about and even use, was particularly vulnerable having lost between 11% and 24% of wealth in only 6.5 years.  Since then a couple of notable things have occurred:

• The 2014 budget saw the income drawdown rules again altered.  From the 27 March 2014 retiree’s are now able to withdraw from their pensions at the rate of 150% of the Government Actuary’s Department Tables (GAD Tables).  Additionally flexible drawdown, allowing unlimited withdrawals from your pension pot, is now available for anybody with a guaranteed income of £12,000.  Then from April 2015 these rules will change again and allow unlimited access to our pensions from age 55.
• The second is that Professor Wade Pfau published research showing a UK retiree positioned with a 50% UK Equities/50% UK Bonds portfolio and drawing down using the 4% SWR rule of thumb would actually run out of wealth 23.8% of the time within a 30 year period.  Scary stuff given how loosely the 4% Rule is bandied around the personal finance blog world these days.  Professor Pfau then calculated that if history should repeat (and of course past performance is not necessarily indicative of future results) then to ensure you don’t run out of money over a 30 year period your withdrawal rate before investment expenses and taxes are deducted has to actually be less than 3.05%. 

Going forwards this is going to make life interesting.  For a retiree to draw down £24,856, the equivalent of current average UK earnings (Office for National Statistics KAB9 dataset), requires wealth (including Pensions, ISA’s and non-tax efficient investments) of £814,950 if we are to minimise depletion risk over 30 years according to Pfau’s research.  At the same time from next year we can grab whatever we like from a pension pot that on average only contains £36,800 at retirement according to the Association of British Insurers.  Of course many of us don’t just save in pensions (for example only 43% of my wealth is in a Pension of which only 14% is sitting with expensive inflexible insurance companies) and of course not all of us will withdraw crazy amounts to buy Lamborghinis (if the rules haven’t changed I’ll be withdrawing as much as possible to keep my total earnings just below the Higher Rate tax limit with the difference between spending and withdrawal being put into an ISA) but it’s probably uncontroversial to suggest it does have the potential to leave the uneducated very exposed.

With that in mind let’s look at how our UK Invested Income Drawdown dependent Retiree’s are doing one year on.  For consistency all assumptions are unchanged.  Re-emphasising some of these assumptions:

• Our Retiree’s are drawing down at the stated withdrawal rate plus investment expenses.  This means any trading commissions, wrapper fees, buy/sell spreads and taxes have to be paid out of the earnings taken.  For example, our 2% Initial Withdrawal Rate Retiree is actually drawings down at between 2.25% and 2.36% dependent on the asset allocation selected.   
• All calculations are in real (inflation adjusted) terms meaning that a £ in 2006 is equal to a £ today.
• 6 Simple UK Equity / UK Bond Portfolio’s are simulated for our retiree.  The UK Equities portion is always the FTSE 100 where the iShares FTSE 100 ETF (ISF) is used as the proxy.  For the bonds portion a simulation is run against UK Gilts (FTSE Actuaries Government Securities UK Gilts All Stock Index) where the iShares FTSE UK All Stocks Gilt ETF (IGLT) is used as the proxy and the bond type I prefer in my own portfolio, UK Index Linked Gilts (Barclays UK Government Inflation-Linked Bond Index), where the iShares Barclays £ Index-Linked Gilts ETF (INXG) is used as the proxy.
• The wealth accrued at retirement (the 31 December 2006) is £100,000.  To simulate a larger or smaller amount of wealth just multiple by a constant. For example if you want our retiree to have £600,000 just multiply all the subsequent pound values by 6.

The RIT High Yield Portfolio (HYP) – Update and Adding PSON and RDSB

When I reach Financial Independence in less than 3 years I'm going to be presented with a number of options, one of which will be to take Early Retirement.  Should I take that option I've already telegraphed that based on my current research I will start withdrawing from my wealth at the rate of 2.5% of total net worth on retirement day.  Ideally, this strategy will have then given me the option to increase my spending at the rate of inflation annually while ensuring the pot of gold at the end of the rainbow is never extinguished.  Of course I won’t blindly follow this strategy but will instead monitor closely and should that black swan arrive will cut my cloth accordingly.

As the do I take Early Retirement question looms I also want to make sure I have sufficient confidence in my financial situation that I don’t fall into One More Year (OMY) Syndrome but instead make the decision on will I or won’t I for purely non-financial reasons.  One thing that would build financial confidence and hence take some of the do I have enough doubt away was if my dividends and interest being earned across my portfolio exceeded the withdrawal rate from the portfolio allowing some reinvestment even in retirement.  Were I to retire today I estimate that after purchasing a home and moving my employer defined contribution pension into my SIPP my dividend plus interest yield would be 2.53%.  So right on the targeted drawdown amount.  Continuing to build my High Yield Portfolio (HYP) should increase that percentage.

The Buck Stops Here

Some might think this post a little cynical however I've found that it sometimes pays to be a little cynical so here goes.  Businesses and their marketing machines have few goals on their mind.  One of those is to remove as many pounds and pence from your pocket as legally possible.  Ideally they then get to do this more than once.  They then try and get you not to notice how many notes and coins you’re counting out by bringing other businesses into the game that can help you to pay the original business in one electronic form or another.  They certainly don’t assess whether the purchase will benefit you or your family’s life.  It’s nothing personal.  It’s simply maximising the revenue.

Once those businesses have completely emptied your pocket worry not.  That’s because another business will come along who will provide you with a product of one type or another that will allow those previous businesses to remove pounds and pence that aren't even yet in your pocket.  They also don’t assess whether the purchase will benefit you or your family’s life and are again simply looking to maximise the revenue.  It’s nothing personal.  It’s simply maximising the revenue.

You might even work for one of those businesses.  Again, they are not interested in whether the salary paid brings benefit to your family’s life or if you need additional State support simply to exist.  They are simply trying to pay you and all your colleagues the least amount possible that will prevent empty desks either in the form of people leaving and/or new people not joining.  If this should occur then some other business will maximise the revenue at their cost.  It’s nothing personal.  It’s simply maximising the revenue and profit.

The Path to Early Financial Freedom, Bicycles Optional

In my hunt for Early Financial Independence, maybe even Early Retirement, I'm unrelenting in my efforts to minimise my spending while not sacrificing the elements of family life that are really important to us.  This is essential behaviour as finding ways to minimise spending allows two things to occur:

• the reduction in spending allows another advance towards the Financial Independence goal  because it can directly become savings; and
• importantly by spending less the Financial Independence goal posts also move towards you.

There is however one area where this is not an appropriate course of action – spending required to earn money.  Generally, if you were just looking to minimise spending you’d be looking for the highest paying job where housing costs were low and your home would be within a walk or cycle to work.  Other considerations for some might include minimising child care or ‘uniform’ costs to name but two.  In the extreme this would be home working.  This is of course flawed because we need to actually be finding ways to Save Hard and not just spend less.  The mathematical way to think about it is Saving Hard is maximised by maximising earnings (which in a family unit could be 2 or more salaries), minus tax, minus national insurance, minus spending required to earn.  Of course it’s then appropriate to be unrelenting in your efforts to minimise your spending required to earn.

Valuing the UK Stock Market (FTSE 100) - June 2014

When nominal charts of the FTSE100 start looking like this:

Click to enlarge, Source: Yahoo Finance

Which are showing us being within 1% of the nominal 30 December 1999 record high of 6930, the chatter in the mainstream media about the potential to reach new highs kicks off.

So what do I think about the potential to reach new highs?  Well I don’t actually even waste brain power considering it for a few reasons:

• The most important is that my investment strategy is no longer based on any form of emotion but is instead now purely mechanical.  This was done because early on in my DIY investing career I realised that no matter how much energy I expended I actually had no idea whether the market was going to go up, down or sideways.  A lot of people out there do claim to know but from what I can see most of these seem to make their money by commenting on it in the media, writing books on the topic or by selling investing newsletters.  If they really do know why are they expending energy doing this rather than making a fortune trading with this great knowledge?  I really do now believe that unless you have inside knowledge, which you can’t profit on legally, then they are all actually just like me.  They have no idea. 
• As I’ll show in this post the market is actually nowhere near a new high.
• Again, as I’ll show in this post, while I believe the market is slightly overvalued it’s still only in the bottom 17% of monthly valuations since 1993.   

Let’s run the numbers.  Firstly we’ll remove the excitement and normalise the data by:

• Correcting the chart for the devaluation of the £ through inflation.  For this dataset I use the Consumer Price Index (CPI) to devalue the £.
• Plotting the Pricing on a logarithmic scale as opposed to a linear one.  By using this scale percentage changes in price appear the same.