An index-linked gilt ladder is oft touted as solving two big problems for investors:
Hedge against unexpected inflation – something that by contrast inflation-linked bond funds have conspicuously failed to do recently.
Ensure a predictable supply of real income to meet living expenses in retirement.
And it’s true! A ladder of individual linkers can deliver on both these scores…
…but you have to watch your step.
Linker ladders solve some risks while introducing others.
So let’s run through the two main use cases, examining the pitfalls and potential remedies as we go.
‘Safe’ retirement income
In principle, an index-linked gilt ladder is a much safer way of generating a retirement income compared to a volatile portfolio of equities and bonds.
Buying a series of linkers enables you to secure a reliable cashflow of government-backed, inflation-protected income.
Hey Presto! No more sequence of returns risk.
See our member’s article on how to build an index-linked gilt ladder for further details.
A linker ladder has two big problems however:
The danger you outlive your ladder. You build a ladder to deliver 40 years of income but then you have the temerity to last for 41. This is longevity risk incarnate.
Relying 100% on ladder-generated income requires you to predict your after-tax living costs far into the future. Get it wrong – with insufficient alternative sources of income – and you land on the liquidity risk square. “Do not pass go, do not collect £200…”
Unexpected bills are as inevitable as their more infamous ‘death and taxes’ counterparts of gloom. Your financial firepower may have to deal with waves of such baddies in the future. Think divorce, chronic health expenses, family members in need of support, and social care – to name just a few end-of-level bosses.
Moreover, your personal inflation rate may outstrip official measures. Which means RPI increases in purchasing power from linkers may not cover your needs.
Please sir, I need some more
Twenty years ago a laptop, a broadband Internet connection, and a mobile phone were not an essential part of life, never mind retirement.
Nowadays pensioners without these items find themselves sidelined by society.
Who knows what’s coming next? Personally, I’m factoring in a neural uplink plus bionic exoskeleton maintenance plan.
Meanwhile, higher taxes in the future could leave you with a lower net income than you anticipated. The country isn’t getting any younger, after all. The national fairy godmother isn’t waving her wand over the raggedy NHS. The military aren’t sure about that nice Mr Putin and there’s an energy transition to pay for.
True, you could sell an individual linker ahead of time to cover an emergency. But do so and then what happens when you arrive in the year 2049 and the gilt that was meant to fund that year is already spent?
It seems the twin threats of longevity risk and liquidity risk must be met by more than a ladder.
The floor and upside strategy
A floor and upside strategy can provide a middle ground between going all-in on a linker ladder, and depending entirely on the favours of the stock market gods.
Here your floor can be built from any blend of linkers, escalating annuities, the State Pension, and defined benefit pensions. Anything inflation-linked that provides ‘guaranteed’ income is ideal.
At the bare minimum, your income floor should cover your essential spending requirements. (That is, your non-discretionary expenses.)
Beyond that the upside is handled by a portfolio of investment assets. Fully 100% equities is often prescribed because the floor element effectively counts as your bond allocation.
The upside portfolio’s job is to grow and provide for the fun stuff. That is, it pays for the discretionary ‘nice-to-have’ part of your lifestyle.
You can dip into the upside portfolio to fund unexpected expenses, too. It can also extend your linker ladder if that nears exhaustion while you’re still going like the Duracell bunny.
Your precise floor and upside formula depends on your personal circumstances. If your entire income (discretionary and non-discretionary) is amply funded by defined benefit pensions then you can afford to be more aggressive with your upside portfolio.
On the other hand you’ll need to be careful if operating on a super-lean essentials budget that’s barely covered by your ladder and an ‘It’ll be alright on the night’ personal philosophy.
Cutting it fine is not recommended.
Annuities are the right tool to combat longevity risk
Annuities come in for a bad rap. But index-linked (or escalating) annuities solve the longevity problem by providing inflation-adjusted income for so long as ye shall live.
If an escalating annuity funds the same income as your linker ladder – but for similar or lower cost – then it’s by far the better choice.
The older you are, the more likely it is that an insurer will offer an annuity product that makes it worth your while. (Though it’s interesting/alarming to note index-linked annuities are no longer available in the US.)
The key point is that an annuity income lasts as long as you do. In contrast, a linker ladder’s lifespan is finite (unless you can keep extending it using cash drawn from other resources).
You can quickly check the going rate on annuities with Money Helper’s excellent comparison tool.
Make sure you choose an annuity that’s linked to RPI and not one of the lesser ‘increasing income’ options.
At the time of writing I was quoted the equivalent of a 4.1% sustainable withdrawal rate (SWR) for a 65-year-old on an escalating annuity.
That compares well with a 3.9% withdrawal rate for a 30-year linker ladder. It also sidesteps the gymnastics needed to wring a similar SWR from a volatile equity-heavy portfolio.
People tend to shun annuities because they don’t like handing over a big bag of swag to an insurance company.
Perhaps those people have not heard of a floor and upside strategy?
Moreover, they probably don’t realise that mortality credits make annuities the cheapest way to beat longevity risk.
Mortality credits are like the bonus balls in the lottery of life.
In annuity land, the spoils go to the long-lived.
Supercentenarians make annuity managers weep as they win their personal bet with the insurance firm.
One can almost imagine shady annuity goons trying to drop pianos on sweet old ladies in the street as the insurers desperately try to stem their losses.
But there’s no need, because they collect on those who fall at the early fences.
The house always wins. But so do you if you last long enough – and durability is precisely the risk you’re insuring against with an annuity.
Of course, linkers are backed by the UK government. But annuities are backed 100% by the FSCS protection scheme. During a crisis that may well amount to the same thing.
Juggling linkers, annuities, and the state pension
If you retire too early to make an annuity cost-effective then building a linker ladder to carry you to state pension age is a viable strategy.
The state pension will then help with the heavy-lifting from age 67, 68, 106 – or whatever your qualifying age is. (Unlucky, Generation Alpha!)
At that point, you can also decide whether to fund the rest of your income requirement from your upside portfolio, an annuity, a linker ladder, or a patchwork of them all.
Monevator reader @ZXSpectrum48k has sketched out a helpful example of how this might work.
Picture a couple of early retirees, age 55. Their vital statistics are:
Essential income: £21,000
A linker ladder funds £28,000 of income for 12 years until the State Pension arrives.
The linker ladder costs £320,000, leaving £380,000 for the upside portfolio.
The upside portfolio can then be left alone for 12 years, so long as the linker ladder is supporting expenses.
Alternatively, if a bombshell bill hits you could sell the portfolio down a bit to meet the payment. This will likely be fine provided you’re not systematically plundering it.
Then from age 67 the state pension (x2 in this case) takes over from the linker ladder to bankroll essential income.
Even if the Upside portfolio only stands still for the next 12 years, it could fund the remaining £7,000 of discretionary income at a mere 1.8% withdrawal rate. That’s pretty safe.
Let’s say the portfolio actually caved in by 50%, in real terms. It could finance discretionary income thereafter at a near 3.7% SWR.
That’s a reasonable SWR too, but especially so after a 50% decline. That’s because stock market valuations will have contracted. And the evidence generally shows that lower valuations support higher SWRs.
(Of course the 3.7% SWR is higher risk than the 1.8% SWR. And you’d leave a smaller pot behind for your heirs if withdrawing at a higher rate.)
Something for the weekend
Alternatively, from your late sixties onwards you could periodically check index-linked annuity rates. At some point your age and health are likely to make annuities a good deal for delivering the remainder of your income. Even more so if you don’t want the burden of managing a portfolio in your dotage.
Personally I’d still leave something in my ‘Upside pot’, regardless of whether or when I bought an annuity.
In later life this allocation could come to represent one last spin on the wheel of fortune.
Will it defray unwished for emergencies? Fund round-the-world trips, grandchildren, or a legacy? Or just fizzle away in an almighty stock market crash? (In which case, thank goodness you built your income floor first).
Much depends on the cards you’re dealt.
How long should an index-linked gilt ladder last?
Our example demonstrated that the length of an index-gilt ladder depends on what you’re using it for.
The doubt creeps in if you want it to last the rest of your life – so long as your date with destiny remains a tantalising mystery.
For context, according to the ONS’s UK life expectancy calculator, a female has a 6.8% chance of blowing out the candles on her 100th birthday cake.
Your income, health, and family history may indicate your chances are better.
I think longevity risk is easier to handle than liquidity risk. So I’d be inclined to overcook the length of my ladder.
Our post on life expectancy will help you think through the issues.
Take a butcher’s at our piece on life expectancy for couples too if you really like your other half. The odds are surprisingly high that at least one of you will last a very long time.
Meanwhile, if you’re using a linker ladder to meet a future expense (but without spending income en-route) then see our post on duration matching. Reinvest those coupons!
Upside portfolio management
Sustainable withdrawal rate research typically shows that 100% equity portfolios entail more boom or bust scenarios than more diversified allocations.
The unpredictability of equity returns can result in anything from you dying very rich to watching your portfolio drain inside a decade.
The lower your SWR, the more probable it is that a 100% equity bet pays off.
Conversely, SWRs much north of 3% from a global equity portfolio are edging into the danger zone.
Consider diversifying beyond global equities if your SWR is above 3% when you retire and the global CAPE valuation metric is well above its historical median.
A 90/10 split between equities and conventional bonds or an 80/10/10 division between equities, bonds, and commodities give you more options to fall back on when the stock market hits the skids.
In reality, your overall position should be more stable than implied by these equity-skewed allocations. That’s because your guaranteed income products and pensions all count as fixed income.
Using a rolling linker ladder to hedge unexpected inflation
You may not want to buy a linker ladder for the rest of your life, but maybe you’re still interested in protecting a wedge of your wealth from being withered by inflation.
Equities will probably do that over the long-term. But in the short-term, individual index-linked gilts held to maturity better fit the bill.
By holding each linker to maturity you avoid the price risk that has hammered inflation-linked bond funds over the past couple of years.
Bond managers typically sell their securities before maturity in order to maintain their fund’s duration.
As interest rates took off in 2022, managers were therefore booking capital losses as prices fell in response to rising bond yields.
Those capital losses were severe enough to swamp the inflation-adjusted component of linker returns.
The bottom line is you can avoid price risk by acting as your own bond manager and holding your index-linked gilts to maturity.
To hedge unexpected inflation with index-linked gilts:
Follow our How to build an index-linked gilt ladder guide.
Construct a shorter rolling ladder instead of the long, non-rolling ladder discussed in the guide.
Hold 0-3 or 0-5 years worth of index-linked gilts – just as a short-term bond fund would.
When a linker matures, reinvest the proceeds into a new linker at the long end of your ladder.
Now you have an investment that directly responds to UK inflation.
You can reinvest your coupons into the ladder whenever you have enough piled up to make it worth your while. Or you can spend them, or reinvest them into another asset.
However you must reinvest the coupons if you want to achieve – approximately – the yield-to-maturity on offer when you first buy each bond. (This involves duration matching and is difficult to do perfectly.)
Remember, your linkers’ pricing will still bounce around as market conditions change. So you’ll still feel the volatility if you track your gilt’s fortunes from month to month. Moreover, you’ll crystallise any loss (or gain) if you sell early.
However, all told the volatility should be relatively tame on short-term linkers. And, as mentioned, you can ignore it entirely if you hold your gilts to maturity.
We’ll write a post soon on how to buy individual index-linked gilts.
But in truth – providing your platform offers them – it’s not much harder than buying a fund or share.
Granted you may have to buy over the phone instead of online, but it’s completely doable.
After many years of negative yields, individual index-linked gilts are affordable and worth buying again.
The window may not stay open forever. We might well fall back into negative real yield territory.
But for now, in an uncertain world, linkers offer something few other investments do. Just so long as you know how to make the most of them.
Take it steady,
Linkers being the colloquial term for index-linked gilts.CPIH after 2030
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