Monday, April 17, 2006

Yield and drawdown of capital

The fourth of the five critical assumptions used in preparing the retirement plan relates to the yield on the retirement portfolio and the absence of reliance on drawdown of capital.

It was assumed that a portfolio of shares and property could generate a yield of 4% per annum (after expenses but before taxes) and that this yield should be sufficient to maintain the desired standard of living without the need to draw down capital.

A look at the share market tables for Hong Kong shows that while the average yield across the market as a whole is less than 4%, it is possible to create a portfolio with an average yield of 4% without resorting to the equity equivalent of a portfolio of junk bonds. Likewise, it is possible to acquire residential property in Hong Kong which will show an ungeared yield (after outgoings) of 4%. Of course, the boyant economic conditions of the last few years have made things harder but it is still possible. It is also true that a 4% yield is nothing to get excited over - in more favourable market conditions it is possible to acquire assets which show much better rates of return.

The point about shares and property which I made in previous posts was that the income derived from investments should grow over time to compensate for the effects of inflation. That potential to grow is highly dependent on not spending the capital. There is of course a world of difference between having the potential to do something and actually doing it.

The second part of this assumption is that the retirement plan should not rely on capital drawdown as a means of funding living expenses. There are two sound reasons for this approach. The first is that spending capital will signficantly compromise the ability of the portfolio to withstand the effects of inflation. The second is that if a lengthy retirement is planned (say 30 years or more), then reliance on capital drawdowns is a highly risky strategy. Over an extended time period, even small errors in the rate of return or the estimates of expenses or a single large adverse event can devastate the portfolio beyond repair. No thanks, I'd rather sleep soundly at night.

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