Letters to Oana: Part 1

Hello and welcome back to Mortgage Advisor on FIRE and the first in a new short series of posts which I’m calling Letters to Oana. This series is designed to break down FIRE to the absolute basics and give someone with no prior knowledge about investing enough information to manage their financial future.

Disclaimer

This series, like the rest of my blog, is not advice for my readers. This is for entertainment and discussion. If you want advice, I suggest speaking with a qualified professional. In no way should my blog be taken as advice or a recommendation.

Background

Two things prompted this post; Oana asked me for a basic “how-to” guide for investing. She wants a simple step-by-step guide for what to do with money and investing should something happen to me. I think this is a great idea and rather than writing it out for Oana alone, I thought it would make a good post that would interest others.

The second thing was a discussion on a recent episode of The Skeptics Guide to the Universe podcast. In the episode, they talked about how someone who is an expert in a subject can be thrown when asked a question by someone with little or no knowledge. The idea is that the person asking the question doesn’t know enough to ask the right questions, so the expert has to spend time working out what is being asked or find the errors in the question.

I told a friend of mine, who is seemingly a source of infinite knowledge about investing, about this series. He suggested a TLDR for this post, which I’ll now share:

1 – Read The Simple Path to Wealth.

2 – Invest in VAFTGAG.

3 – Ask him for advice.

Being knowledgeable about a subject isn’t just knowing the answers, but also knowing the right questions to ask.

Anyway, on to the post itself.

So you have money to invest…

I’m going to break all this down using a hypothetical scenario in which I’ve passed away and left my assets to Oana. She will then have the task of investing and managing those assets. For simplicity’s sake, I will use a nice, easy figure for the total value of the assets; £200,000.

Assuming this is all left to Oana as a cash lump sum she will have several decisions to make. The first is whether to use the money to invest or to put towards paying off the mortgage. If she can afford the mortgage payments, it would generally be better to invest the money. A mortgage will be repaid eventually, but the money invested can earn a return indefinitely.

So, the task now is to decide how and where to invest. To arrive at an answer, Oana will need to ask herself a few questions…

When does she want to access the money?

What is the purpose of investing?

I asked Oana this question and she said it would be to retire early, which answers both the above questions. For someone who wants to pursue FIRE in the most basic way possible, it’s a pretty simple exercise which can be broken down into four distinct stages. I intend to break each stage down into a dedicated post. This one focuses on the Accumulation of Assets.

Accumulation of Assets

The ISA Bridge

Drawing down your SIPP

Accessing your State Pension

Within each stage, there are separate phases which I’ll expand upon later.

Accumulation of Assets

It’s important to ensure that any investment plan is built on a solid financial foundation. You need to make sure that you have spare cash each month once you have accounted for the basics of daily life, such as mortgage/rent, utilities, grocery shopping, and so on. Once you have an idea of how much your cost of living is, you will know how much you can invest.

As part of the above exercise, you must be honest about how important FIRE is to you, and how much you are willing to sacrifice to achieve it. If you are willing to approach FIRE with all guns blazing, you have to accept that your standard of living may be lower or more basic whilst you are accumulating assets. A higher savings rate, as a percentage of your income, will result in achieving FIRE sooner. A lower savings rate means it will take longer.

Another consideration when starting is how much you think retirement will cost. According to the PLSA, a single person could have a comfortable retirement on £31,300p/a. But how to get that level of income?

The 4% Rule

The 4% rule is one of the most important concepts to understand in FIRE, but it’s important to note that the figure of 4% is not necessarily applicable to everyone. The concept I’m talking about is the Safe Withdrawal Rate.

Imagine you have a pot of money, say £500,000, to last for the rest of your life. This money is invested in a stocks and shares ISA or a pension; it doesn’t matter for this example. The main point is you have this lump sum. If this money is invested, it should be growing as the underlying investments grow.

Figures vary, but an assumed average rate of growth is estimated to be between 8%-10% per year. It will not be a smooth increase, but instead will see peaks and troughs over time with some years seeing incredible gains and other years resulting in losses. The idea is that averaged over time, you would expect your investments to grow by roughly 8%-10% each year.

So, taking this a step further, if your investment is growing at 8% and you are withdrawing 4% from your investment each year, you should still expect the value of your investment to grow whilst you are withdrawing from it. The idea is that you have a pot of money that can, in theory, last forever.

Historic Data and Success

Using historic data the FIRECalc website can run projections based on any withdrawal rate to see how likely it is to succeed. £20,000 withdrawn from a £500,000 pot should succeed 95% of the time over a thirty-year drawdown period. The average value of the pot at the end of 30 years is approximately £950,000. (Note: this is an average and in many scenarios, the pot would be depleted by the end of the 30-year term. Having £0.01 at the end of 30 years is still a success).

Different withdrawal rates have different success rates, as you would expect. If you decided to live off £17,500p/a, a 3.5% withdrawal rate, FIRECalc suggests this would work 100% of the time. Moving in the other direction and using a withdrawal rate of 4.5% (£22,500p/a) sees the success rate fall to 83.9%.

The thing about withdrawal rates is they are not set in stone. You may decide to have a higher rate when you are younger, and a lower one as you age. It’s also important to remember that failure isn’t an instant thing. If you are using a withdrawal rate and you see your balance decreasing over time, then you can always readjust your plans to compensate.

Coming back to the figure from the PLSA of £31,300 for a moment, you would need a pot of £782,500 to achieve that income with a 4% withdrawal rate.

Why am I spending so much time talking about the SWR? It’s because you need to have an idea of what value you are aiming for if you want to invest to retire early. The goal will shape the journey.

So what about the accumulation of assets?

We have a starting point; £200,000. We have a goal of growing that pot to £782,500. Knowing Oana, she would never want to give up work entirely. Instead, this exercise is more about FI than it is about RE. Based on that, a 4% withdrawal rate would probably be ok. If she wanted to be FI in fifteen years, what would she need to do?

Assuming an 8% growth rate, Oana would need to add £455p/m to the pot to increase the fund value from £200,000 to £782,500 in fifteen years. That is not unrealistic, but this calculation is too simplistic. Now we have an idea of the rough figures involved, it’s time to break them down using the stages I mentioned earlier in the post.

That’s all for this post, but I will return next week to discuss the ISA Bridge. Thank you for reading.

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