Letters to Oana: Part 2

Welcome back to the special series of posts; Letters to Oana. In Part 1 I gave an overview of the reasons for this blog, and what I was hoping to achieve. In Part 2 I move on to discuss the ISA Bridge.

The ISA Bridge

Early retirement is a dream for many, but the majority of people I speak with seem to think it’s unachievable. It doesn’t have to be. I hope that this series of posts, alongside the main blog, will help people realise that.

The key to achieving financial independence and, ultimately, early retirement is to get organised. You need to view money as a game with a defined set of rules, and different tools you can use to help you progress. One such tool is the Individual Savings Account (ISA), which can be employed as a bridge between stopping work and accessing more traditional retirement tools like pensions.

What follows is a comprehensive look at how you use an ISA bridge to retire early and enjoy financial independence.

Understanding the ISA Bridge Concept

An ISA bridge involves building a substantial ISA balance that you can draw from in the early years of retirement, bridging the gap until you can access other retirement funds. This strategy is particularly useful because ISAs offer tax-free growth and withdrawals, providing a flexible and efficient way to fund your early retirement years. There is generally a fee to maintain a stocks and shares ISA, and these fees can vary massively. Some of the more popular providers are Vanguard, iWeb, and Hargreaves Lansdown, but there are many more in the industry.

When browsing for an ISA provider the fees may seem very low overall. However, the difference between a provider charging 0.5% and 1% can result in thousands of pounds difference in the future balance of your investment. Some people focus entirely on fees, and some, like myself, take a balanced view between fees and the ease of doing business with the provider. I’m paying a little bit more than I could with a different provider, but the website, mobile app, and telephony service are excellent. It’s important to have faith in those handling your investments, and it’s not something you can put a monetary value on.

So, you have your ISA and are probably wondering what is next. Your ISA in and of itself doesn’t do much other than act as a shelter or bunker protecting what is inside from things like income tax and capital gains tax. There is a limit to how much you can invest in a stocks and shares ISA in a financial year, and at the time of writing this limit is £20,000.

How, and When, to Invest

There are two main schools of thought on this. Some favour a pound cost averaging (PCA) approach, and others prefer to invest as much as possible as soon as possible.

The PCA approach involves investing smaller amounts regularly with the idea being if stocks go up, you buy fewer units for your money, but if stocks go down you get more for your money. It can be a helpful approach for those looking to make investing an automatic process because you can set up a regular payment into your ISA, and then have a regular instruction for that payment to be used to invest in your chosen funds or stocks.

This isn’t for everyone though, because some people will have irregular income or may come into a lump sum they want to invest. Some will advocate for splitting a lump sum into smaller chunks to enable a PCA approach but there’s an adage that rings true; “Time in the market beats timing the market.”

Unless you have some insider knowledge or supernatural power to predict the future, no one can consistently predict what stocks will do one day to the next. The general trend throughout history has been growth upon growth but within that, there are peaks and troughs.

Trying to predict these highs and lows is not only impossible but also pointless. Invest what you can, when you can, and then let it grow over time. The longer you are in the market, the more likely you are to experience growth. If you hold off on investing for the perfect time, you will likely be waiting forever.

There’s an old proverb; The best time to plant a tree was twenty years ago. The second best time is now.

What to Invest In

Entire books have been written on this subject but for this post I’m not going to go into the weeds. This is a beginners guide for my partner, Oana, and so I’m deliberately going to simplify terms and concepts. Oana is intelligent and a quick study, but she’s never been interested in this subject before. So, I’m starting at the beginning(ish).

There are, broadly speaking, two types of investment you can buy in a stocks and shares ISA. There are individual stocks, and there are funds.

Individual Stocks

A stock is a small piece of a business. When you buy a unit of stock, you are buying a tiny portion of that company. The more units you own, the bigger your share in the company. Having shares in a business entitles you to benefits that may include things like a dividend payment, or voting rights at shareholder meetings, or certain perks like a discount on products and services offered by that business.

There are times when owning stocks in individual companies can make sense. For example, at the time of writing if you own a single share in Mitchells and Butlers, you will receive a book of vouchers that gives you discounts at some of their establishments like Miller and Carter. You have to own the share on a specific date to qualify each year, but it’s a decent benefit if you like their food.

Other examples of when it can make sense to own units in a specific company include owning shares in your employer if they offer a scheme where you can invest at a discount or via a tax saving mechanism. For example, many businesses offer variations on a share save scheme where you can buy shares at a discount of their market price. There are terms and conditions around this type of scheme, but considering the discount is, at least in the many companies I’ve seen offer this, 20% off the market price, it can result in some fantastic profit.

Owning shares in a single business comes with a major potential risk; the business can fail. This can be a sudden, catastrophic failure, or something more gradual. As a general rule, once the news of a business failing has reached the public, then it’s already too late. Everyday investors will almost never know when the shit is going to hit the fan for a business, whether it’s through corruption, or a failed product, or some other scandal. When you invest in a business you are taking a massive risk. There is the potential for huge gains, but at the same time you can easily lose money. Generally speaking, it’s best for passive investors to avoid investing in single stocks.

Funds

A fund is, for the purposes of this post, a collection of many different individual stocks. When you buy a unit in the fund, you are buying smaller chunks of lots of different companies. For example, let’s take a fund that is based on the FTSE100, which is an index of the 100 biggest companies listed on the London Stock Exchange. If you buy a single unit in the fund, you are buying a tiny chunk of each of those 100 businesses.

There are vast numbers of funds out there based on geography i.e. Europe, Global, North America etc; industry types, such as banking, oil, technology, and so on. There are ethical funds, green funds, and many more.

So, what funds do you invest in?

To answer this question, we have to take the scenic route and cover off a few points.

First of all, you need to understand that you can’t beat the market consistently. Think of it like a casino, you might win the odd time here and there, but in general, over the longer term, the house always wins. It’s the same with the stock market; you can’t beat it, and so you have to learn to go with the flow.

There are people out there who claim they can pick and choose the stocks that are going to perform well, which will allow the fund to return huge profits to the investors. It’s all bullshit. A broken clock is right twice a day, and some funds may have stellar years but over time it has been demonstrated over and over again that you can’t beat the market.

Any investment that claims to offer massive profits should be avoided. If it’s too good to be true, then it’s bullshit. All together now, you know the words…

You. Can’t. Beat. The. Market.

Within the world of investments funds you can lump the funds into two categories; those that are passive, and those that are actively managed.

Actively managed funds are, as the name suggests, managed by an individual or team with the idea they can get the best performance and return from the fund by tinkering with it. At first glance, this might seem like a good idea but, and you know what’s coming; you can’t beat the market.

It has been repeatedly demonstrated that actively managed funds tend to underperform compared to passive funds. One reason for this is the fund has to pay the people to manage it, and as changes are made to the fund, costs are incurred. Where possible, I would always advise Oana to avoid these types of funds.

Passive funds are a much better choice because the costs are lower, and there’s less potential for emotional decision making. Much like a gambling addict, those managing an underperforming fund could be tempted to make riskier trades in an attempt to chase losses. With a passive fund you are simply tracking the behaviour of the index it is tracking. So, if you have a FTSE100 fund, it will mirror what is going on with the index and your investments will match that proportionally. By removing the human factor, you remove the potential for dysfunctional behaviour.

So, having gone the scenic route we arrive at our destination. I would advise Oana to have one fund in her ISA; Vanguard’s FTSE Global All Cap Index, which means her investments will include the biggest companies from around the world.

Although the choice of fund is simple, it’s not the final decision to make. There is then the choice between investing in the income version of the fund, or the accumulation version. Simply put, with the income variety, the profits earned by the companies in the fund are paid out to the investors, but the value of each unit in the fund will remain fairly static. With the accumulation type the profits are rolled back into the fund so the unit price of the fund increases.

Again, whole essays have been written about the pros and cons for income or accumulation, but as this is a basic level guide, for those looking to FIRE, the accumulation type is more appropriate. As for the reasons, there are many articles out there that do a good job of explaining why.

What Next?

To summarise what we know so far.

1. An ISA is a tax-efficient product within which you can invest and avoid paying capital gains and income tax.
2. An ISA Bridge is the term used for when you accumulate funds in the ISA, intending to use those funds to pay for your cost of living from the time you give up work to the time you can draw your pension.
3. Investing what you can, when you can, is the best approach.
4. Although individual company stocks can provide benefits, it’s better to invest in passive funds.

Once you have set up the process you just need to wait for the ISA balance to grow.

How Much Do You Need? How Much Do You Have?

This is something unique to each person. Oana is 35 years old at the moment, and has some modest investments. For the purposes of this post, I’m going to assume she is starting from zero with anything extra being a bonus.

Cost of Living

We all have different standards and styles of living. Oana and I live fairly frugally with our main luxury spending being holidays, Lego, and eating out. No alcohol or recreational drugs. No kids, no car. A comfortable standard of living can be achieved for £1,800pm, if Oana had to do this alone.

The Length of the Bridge

If you retire just one year before the expected retirement age, then you can technically consider yourself as retiring early. For many of us in the FIRE community, though, we are aiming for something a bit more ambitious. For the purposes of this example, I’m going to assume Oana will look to FIRE at 50(ish); fifteen years from now.

Using a target age of 50 she will need a bridging fund that lasts a minimum of seven years, because as things stand 57 is the youngest age she’ll be able to access her private pension.

Our basic calculation is thus; (£1,800pm x 12) x 7 = Required Bridging Fund; £151,200.

Now, I can sense you thinking, “but wait, what about…?” Well, I’m coming to that…

You may be thinking that the bridging fund doesn’t necessarily need to be that high because the fund will continue to grow whilst being drawn down. This could happen, and we need to factor in the risk of a drop in the value of the fund, as well as the impact of inflation. As this is a basic guide, I’m going to ignore those factors and instead talk about failure in general.

Failure

In a financial plan such as this, failure is not an instant thing. You don’t wake up one morning and find you have run out of money. You should, ideally, be keeping an eye on your fund every so often, and if it looks like it’s being depleted ahead of schedule, you can adjust course and either spend less, or take up some temporary work to plug the leak, as it were.

I’ll give an example. If you have a fund of £151,200 you would assume that, over the long term, it would grow at approximately 7%, possibly more. On a monthly basis this would mean approximately £800 growth. If you are drawing down £1,800pm, then the fund would decrease by £1,000 from the original balance. This means that the following month the growth would be roughly £770. Over time, the balance is decreasing.

Following this path would result in finishing the bridging phase with money to spare, but if the fund value drops due to market fluctuations, you could run out of money too soon. As I’ve stated, failure is not instant; if you track the numbers you can see a potential shortfall ahead of time and take steps to weather that storm. If you have to pick up some temp work for a few months, it’s hardly the end of the world.

Accumulating the Bridging Fund

FIRE has two accumulation phases which will run in parallel for much of the journey. There’s the accumulation of your pension pot, and the accumulation of the bridge. I’m focusing just on the latter for now.

Oana has fifteen years to save £151,200. This seems like a huge amount of money, but when you break it down it’s not so overwhelming.

From a standing start, investing £480pm with a growth rate of 7% will achieve the required balance. This is a lot of money each month, but if FIRE is your priority then you’ll need to find a way. It might be that giving yourself an extra year or two to accumulate the funds is the way forward, which also has the added impact of reducing the overall bridging fund you need. Each extra year worked means another year you don’t need to live off a bridging fund, hence the reduction.

A Compromise?

One approach that is popular is so called Barista-FI, with the idea being you don’t give up work completely, and instead you take a role that gives you a bit of income to supplement your plans to live off a bridging fund.

For example, if you were to work two days a week, six hours each day, for the current UK minimum wage of £11.44p/h, you would earn a little over £135p/w. This reduces the annual amount needed to survive from £21,600 to approximately £14,500. If you work out what bridging fund you need to have for seven years at £14,500 it comes to £101,500. This has the effect of reducing the required monthly investment from £480 to £325.

Isn’t Working in Retirement a Contradiction?

Not necessarily. The FIRE acronym has two parts; Financial Independence, and Retire Early. Many who talk about FIRE are, at least those I’ve spoken with, more concerned with the first part (FI) than the second part (RE). It’s not that people don’t want to work, it’s that they want to work on their own terms without worrying about money.

That’s all for Part 2…

In the next part of this series I’ll bring together the accumulation phases for the ISA bridge and pensions. I’ll then move on to discuss drawdown strategies for both of these investments. Whilst knowing how to save is important, knowing how best to use your savings is equally important.

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