Case Study Brief

I was contacted recently by a retired couple called Bill and Ann. Their financial adviser had retired. They were concerned that their investment portfolios had fallen from £140,000 to £121,000 – much of this in the past 12 months. They wanted to know why this was happening.

In 2007, Bill and Ann invested £70,000 each into OEIC and Isa holdings via a platform. Their adviser had invested them both into identical portfolios across a range of bond and equity funds. There were a lot of Gilt funds which had performed extremely well from 2007-2012.
Bill and Ann are now in their mid 70s and have two grown up sons living in Shanghai and Texas. Bill and Ann are in excellent health and enjoy travelling to see their sons and grandchildren each year. This involves two expensive trips every year which has been funded from their portfolios via a regular withdrawal of £800 per month in total.
This is a real life case study. Names and some other details have been changed to protect confidentiality.

The Case Study

The first thing that really seemed important to Bill and Ann, was establishing why their portfolios had suddenly started behaving differently. These clients are realists, they are fairly experienced investors and they know that funds can fall. What they couldn't understand is how their funds had fallen quite so dramatically from one annual statement to the next.
Historically since 2007, Bill and Ann have enjoyed receiving £800 every month from their portfolios while seeing their £140,000 only erode ever so slowly. They had noticed a far swifter fall in value over the past 12 months or so. I got to know Bill and Ann really well over our two meetings. They actually both enjoy reasonably good-sized pension incomes which comfortably cover their day to day costs. They save well over £1,000 per year which they have historically given to their grandchildren. They also hold around £56,000 in cash Isas, but they only feel that they need around £20,000 for actual emergencies long term in cash.
I asked what happens to the £800 per month portfolio withdrawals. They explained that they
save this up in a separate account and then twice a year they purchase their air tickets for the trips to Shanghai and Texas. There is actually money left over which has built up the cash Isas, as the trips are only costing them £9,000 per year at the maximum. I started by fully analysing the underlying funds within the portfolios. There were still some good funds in place, alongside some that have fallen out of favour. While I believed that performance could be slightly enhanced by improving the fund manager choices – the fund selection was not the main underlying problem.

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In looking at the actual portfolios, I noticed two other elements that could be improved. Firstly there was some remaining money in OEICs that could be Isa 'wrapped' for greater tax-efficiency. Secondly, I was uncomfortable with the lack of diversification between husband and wife. I really felt that two separate groups of funds might slightly enhance performance over time. However, I did not feel that these two points on their own explained the current capital erosion.
I went on to run an asset allocation analysis to try and understand the risk strategies that Bill and Ann had taken. The historical volatility of their portfolios did broadly match their 'cautious to moderate' remit, although there was some scope to build in slightly more underlying volatility. However, asset allocation was not in itself the major problem. The real elephant in the room here was the size of the withdrawals. A quick calculation shows us that their financial adviser had originally set up their withdrawals at a level of 6.9 per cent per annum (£9,600 per year on £140,000). This in itself was an ambitious plan, as there have been relatively few periods in history where a relatively cautious investment strategy has consistently delivered 6.9 per cent returns net of tax and annual management charges. Come to think of it, there have been relatively few speculative investment strategies that can live up to this either.
To this end, it was nothing short of a miracle that Bill and Ann had managed to keep their capital so close to their initial investment until late 2012. However, once global equity markets began to recover, so cautious bond funds begun to slow – and the gap started to open up in this financial plan (if we can call it that.) I carefully worked out their current portfolio underlying growth rates and demonstrated that their existing portfolios were only managing a level of 3.2 per cent net of tax and charges per year.
I explained to Bill and Ann that their expectation of a continued £800 per month was becoming more and more unrealistic. I also pointed out that they were no longer operating at 6.9 per cent withdrawals. The £9,600 per year was now coming from just £121,000, so the withdrawal had shifted up to dangerous levels of nearly 8 per cent per year. Furthermore, I explained that I was really uncomfortable just blindly taking income out on a monthly basis - even when funds are struggling. I stated in no uncertain terms that complete capital erosion was on the cards unless several things were adjusted swiftly. Bill and Ann were not entirely convinced. They still wanted to be able to enjoy those two trips per year and they had become used to the £800 per month. Why would they trust me when their past adviser had appeared to do so well until recently? I needed to demonstrate very clearly what was going wrong here, and to do it in an impartial way. I decided to run a cashflow model using a very simple Excel spreadsheet that we keep for such instances. I inputted the current portfolio value of £121,000. I also inputted the current underlying growth rate and their £800 per month withdrawals. The net result showed complete capital exhaustion at around year 16.

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While this would take Bill and Ann to around age 90, they were very unhappy when faced with these figures. They pointed out to me that they still want some of their capital around in later years even when they have stopped flying out to see their sons. I wasn't much comfort as I also reminded them about the effects of inflation on their remaining capital. I pointed out that they are likely to seek to actually increase these withdrawals as air fares rise. They were now onside in realising things needed adjusting. I had six key concerns about their current portfolios and financial plan as follows:
Firstly, their withdrawal was far too high to be sustainable. They have been taking £9,600 per year when they only actually needed £9,000 per year in today's money. The portfolio has been decimated through a poorly conceived withdrawal plan and really needs a rest.
Secondly, monthly withdrawals are really not the answer in this case. A strategic withdrawal at the annual point in future will at least allow us some flexibility about when we time the withdrawal in accordance with markets at the time.
Thirdly, I felt that their underlying funds needed some adjustment to weed out poor performers and replace them with funds that might be more likely to boost returns slightly.
Fourthly, there appeared scope to increase the risk strategy slightly for one of their portfolios. I wondered if one of them would agree to allow me to run with slightly more equity funds within their asset allocation – to enhance potential long term growth.
Fifthly, I was troubled by the replication of funds across both clients' portfolios. I felt that less exposure to one particular fund manager could be achieved through separate fund holdings.
Finally, it seemed prudent to fully Isa their remaining funds within their portfolios to maximise their portfolios tax efficiency and ultimately assist potential growth.
I summarised that Bill and Ann actually only needed £9,000 per year available to fully cover their very precious trips to see their family, not the full £9,600 being currently taken from their portfolios. I started by hunting around for other areas within their finances that could be used to help rescue this overworked portfolio. The first thing that I raised was the £1,000 per year disposable income that they tend to give away. I asked them which was more important to them – gifting some cash to grandchildren or physically spending time with them. The answer was very swiftly spending time with their grandchildren. To this end, we agreed to reallocate this £1,000 per year income towards the £9,000 air fare costs. Bill and Ann have no Inheritance Tax issues, so this reallocation of funds for at least a few years made sense. 

Next I focused on their £56,000 or so of cash funds which are attracting little interest and not being used to help their situation. I asked if we could consider funding the remaining £8,000 travel costs from this for a while. Bill and Ann were comfortable with this down to around £20,000 which they felt should remain as an emergency fund. I completely agreed with this. I considered a plan to use their cash funds for the next three years to cover the £8,000 per year shortfall in their travel costs. This came to around £24,500 allowing for inflation at 2 per cent per year over the next three years and will still leave them with around £31,500 in cash funds plus a little interest. This leaves £11,500 slack within the plan.

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Hopefully the rested portfolio will have regenerated some of its capital by then. After carefully looking at historical portfolio trends for the revised asset allocations, we worked on a 5 per cent assumed annual increase in the portfolio. This takes the beleaguered £121,000 up to a potential £140,072 in three years time, which at least potentially repairs the portfolio to its original starting point in 2007. We will then consider funding the travel costs for that fourth year from the portfolio once again. The figure required of £8,000 adjusted for inflation at 2 per cent per year will equate to around £8,659 at that point. This figure on a portfolio of £140,072 will still equate to a very high withdrawal of around 6.2 per cent per annum. However, this plan at least allows for inflation and it is better than the current 8 per cent and rising level.

Crucially, we have provision to stall the withdrawal if markets are looking a bit sick at the time – because of the £11,500 cash back up.

What Happened Next

Bill and Ann agreed to stop gifting disposable income and to instead apply it to the important annual trips to see their family.
They also agreed to fund the trip shortfall from their cash for around three years. I completely remodelled both portfolios – using the best available funds.
Ann has a balanced equity and bond portfolio. Bill has a slightly more speculative portfolio with less bonds and more equities.
We 'Isa-wrapped' their remaining funds and established their new portfolios on our quarterly monitoring system to hopefully help the portfolios do as well as possible over the longer term.
Ultimately these portfolios are still going to erode. As with so many real life financial plans there is no perfect solution. The point here is that Financial Planning is all about being honest with our clients. Ignorance is bliss until it all starts going wrong.
I wish I had met these clients a couple of years earlier, but at least we can now try and stem the flow of capital, so that Bill and Ann are wealthier for longer.

Key Points

1 The original plan set up regular withdrawals that were unrealistic in relation to the underlying investment holdings.

2 The underlying funds had not been monitored for some time and consequently were not all the best funds available.

3 Through the use of cashflow modelling
we could show the clients what was likely to happen to their capital in an impartial and effective way

Biography: Darren Lloyd Thomas CFP^CM of Thomas and Thomas.

Darren set up Thomas and Thomas with his wife Lisa in 2006after they had both worked as IFAs for various companies.
They both had a vision of a purely fee-based local family business that would utilise cutting edge technology and knowledge to offer something different
in their local community. In 2008, Darren successfully achieved his Certified Financial Planner^CM certification which helped him to develop a service based Financial Planning business – moving fully away from the transactional model.

He has built up the business purely on word of mouth recommendations from 31 clients in 2007 to 158 in 2014 and some £30 million under management.

This email address is being protected from spambots. You need JavaScript enabled to view it. 01437 772228
www.thomasandthomasfinance.co.uk