How much Income Reserve?

[Arborbridge]

Using the examples in the "HYP1 is 16" thread, I looked at the question of IR, and how big it should be for comfort. I understand that history never quite repeats, that the result is dependent on inflation and the relationship between that and how strongly companies can grow their dividends after a crash, and on one's own particular HYP. However, given that we only have two examples to go by, I thought it worth repeating the exercise to give a rough and ready answer to the queston posed.
I've assumed for both illustrations a required income of £1000pa and a naive average RPI increase of 3% pa.
First up TJH's income experience from the year 2009 onwards when the worst of the fall happened. The first column is TJH income per unit used for each year.

Code: Select all

         income needed    inc received    deficit
22.16    1000             1000
11.59    1030             523.0144        506.9856
16.71    1060.9           754.0614        306.8386
18.32    1092.727         826.7148        266.0122
20.89    1125.50881       942.6895        182.8193
21.48    1159.27407       969.3141        189.96
22.4     1194.0523        1010.83         183.222
22.77    1229.87387       1027.527        202.3468
                                          1838.184  IR required

This suggests that an IR of 1.8x a year's income should be held in cash, or near cash.

Second example, from the experience of HYP1, starting from the year 2008, and the first column gives the income produced by HYP1.

Code: Select all

        income needed    inc received    deficit
5040    1000             1000
3187    1030             632.3413        397.6587
3297    1060.9           654.1667        406.7333
3843    1092.727         762.5           330.227
4289    1125.509         850.9921        274.5167
5828    1159.274         1156.349        2.924868
5601    1194.052         1111.31         82.74277
6093    1229.874         1208.929        20.94529
6124    1266.77          1215.079        51.69072
                                         1567.439  IR required

This suggests an IR of 1.5x a year's income should be held..

What is interesting - nay depressing - about both sets is how slowly the income builds after the cash. I'm also painfully aware of the difficult of applying these sets to any new scenario which may unfold in the future, but the result seems in line with what people have written previously. This might only be because previous writers have used the same HYPs, however! What does seem true, is that I will continue to be frustrated by holding quite large amounts of cash earning next to nothing as a lifeboat, and that I cannot reduce that amount without extra risk.

Arb.

[Jon46]

Arb

This could lead to a very interesting discussion imo.

However, in the first case, the number of units could have in all probability increased considerably if not all income was taken, which is what TJH does I think, thus the actual income would have moved at a much greater pace. So that case A and case B are not directly comparable.

Jon

[Arborbridge]

Jon,

Yes, true, the income per unit does not preclude an increase in real income. However, I'm pretty sure if the income had declined by 50%, the number of units would not be increasing quickly thereafter. But it's a good point, and one for Terry to clarify, I think.


Arb.

[midgesgalore]

Very thoughtful Arb but that is only a part of the HYP srategy. I wonder how the figures would change if the other discipline we use, Safety Margin (SM), is deployed?

If you were to re-run your numbers with, say 25% dividends reinvested would alter matters.
That probably works best if you start the first year withdrawing the needed £1000 whilst the HYP produces £1333.33 such that the £333.33 is allowed to re-invest?

midgesgalore

[pendas]

Arb,
I have some figures from 2006/7 if you want to play around with them. I retired at age 59 in 2007 and had a 6 year gap to fill before the state pension kicked in. The target at the time was a £150K purchase cost producing a £7.5K annual income. The following income figures have been adjusted to assume a mid year purchase cost each year of £150K whereas in reality the capital was built up to that figure over a number of years.

Code: Select all

2006/7    £7164
2007/8    £5985
2008/9    £7395
2009/10   £4643
2010/11   £5492
2011/12   £6348
2012/13   £6436

As you can see I got close to the target in only 2008/9, although the first year may have achieved it, if it were not for dividend drag. Inflation has not been accounted for either.

[Dod1010]

Since I do not unitise I cannot help very much with Arb's OP but I would be uncomfortable with less than one year's income in cash as a reserve. As it happens, I draw capital occasionally (from my SIPP mostly) to help with say an unexpected household repair, new car, help my family or some unexpected expense, and so I have around four years income in cash mostly in Index Linked NS certs.

That is a comfort blanket and means that I do not worry about income reserves or safety margins and so on. It is also a deliberate asset allocation measure and in theory at least preserves my purchasing power plus a tiny bit extra. If I rollover the maturing certs without extracting any income, it is surprising how well the compounding effect builds up the lump sums.

I do not recall any particular income difficulties in 2008/9, and I did not draw on cash reserves. I think I just curbed my expenditure a bit.

[Arborbridge]

midgesgalore - I assume you might live in the highlands from your name?

The Safety Margin: I've assumed that if one's income dropped 40-50% the SM would not exist until the income had built up again. Yes, one can make other assumptions, but that might lead to sailing closer to the wind.

Pendas: I may do that, but your drop of 40% is rather similar, so I guess wouldn't be much different. I also note your figures only go to 2013 so doesn't include a complete data set.

Dod, I think we've discussed this previously. Certainly if one had significantly more capital than one needed to provide ithe necessary income, it would not be a surprise if you "didn't recall any difficulties". Then be all means, don't bother with an IR. However, many of us are not in that happy position.

Actually, looking at the slow way income is recovering, it wouldn't be a surprise if we only had a year or two to build fat before the next big bear comes along.

[midgesgalore]

midgesgalore - I assume you might live in the highlands from your name?

The Safety Margin: I've assumed that if one's income dropped 40-50% the SM would not exist until the income had built up again. Yes, one can make other assumptions, but that might lead to sailing closer to the wind.
...
Actually, looking at the slow way income is recovering, it wouldn't be a surprise if we only had a year or two to build fat before the next big bear comes along.

Not quite the highlands but the little critters inhabit lowland regions too - especially in the calm of the few evenings we get calm.

Anyway I meant you would not embark in withdrawing 100% of dividends to start with or that might be asking for trouble. Some folks say a withdrawal of between 3% to 4% is sustainable whereas the gross yield people report in these forums is more a minimum of 4.5% and I have seen higher reported. Therefore the rest (we can say SM) of the dividend should be re-invested. The extent that some of the SM is re-invested is then benefiting from compounding over the years.

midgesgalore

[Arborbridge]

Yes, I think we mean the same thing in a different way. As regards my illustration in the table, the £1000 starting income is assumed to be the total income generated from all the equity including the built up SM accumulate to that date. If your SM had already built up to the point where the total equity income available exceeds your requirement by a factor of 2, I doubt whether the IR discussion would be necessary - see my post to Dod.

I'm not too acquainted with lowland midges but I know well those on Skye from camping/scrambling days. Funny how they never write about them in the tourist leaflets
Arb.

[Dod1010]

Arb

I do not want to the give the impression that I have got huge chunks of surplus capital. I think that the sort of question you pose is difficult to answer without having some idea of our annual expenditure because for instance I now live on my own in a very nice house and have what many people would call a good lifestyle but I do not spend a lot of money annually. (Even that is subjective is it not?)

Anyhow one year's income as a reserve would be my minimum.

[Arborbridge]

Anyhow one year's income as a reserve would be my minimum.

Seems about right to me.

[micrographia]

Good to see the board has a new home!

Recall from previous discussions that individual positions on income reserve and safety margins were largely dependent on a persons situation, as Dod has pointed out. In particular, whether the HYP was to be the only income source or used in conjunction with other income streams. If the former, 12 months reserve seems prudent, though 18 months seems like overkill to me - a benefit of a HYP is the ability to burn capital to temporarily shore-up income if necessary.

In my case HYP income is likely to represent a useful supplement to my retirement income with pensions hopefully supplying enough to live comfortably on. As now, I'll be happy with 6 months worth of outgoings in cash, which will actually be less than I hold now since I won't have to service a mortgage. This will likely be there to dip into should the kids need some help, since I'm less likely to lose my pension income than a worker is a job.

There are midges in the Dales as well, though nothing so far approaches the horrors of Argyll or, God forbid, Skye on a warm still evening...

Regards, EEM.

[Gengulphus]

As a general comment, I think you want both a Safety Margin and an Income Reserve. While you're suffering from major dividend cuts, having the Safety Margin makes the Income Reserve more effective by reducing the amounts you have to withdraw from it; afterwards, it helps you refill the Income Reserve, and then when the Income Reserve is back up to the level you want, you can reinvest it to increase the Safety Margin and make yourself still safer, or just splash out with it if you feel no further safety is needed.

E.g. take Arb's example of a 2009 starting year in TJH's record:

Code: Select all

         income needed    inc received    deficit
22.16    1000             1000
11.59    1030             523.0144        506.9856
16.71    1060.9           754.0614        306.8386
18.32    1092.727         826.7148        266.0122
20.89    1125.50881       942.6895        182.8193
21.48    1159.27407       969.3141        189.96
22.4     1194.0523        1010.83         183.222
22.77    1229.87387       1027.527        202.3468
                                          1838.184  IR required


and modify it to have an initial 10% Safety Margin of income received over income needed:

Code: Select all

         income needed    inc received    deficit
22.16    1000             1100
11.59    1030              575.3159       454.6841
16.71    1060.9            829.4675       231.4325
18.32    1092.727          909.3683       183.3587
20.89    1125.50881       1036.9585        88.5503
21.48    1159.27407       1066.2455        93.0286
22.4     1194.0523        1111.9134        82.1389
22.77    1229.87387       1130.2798        99.5941
                                         1232.7872  IR required


So about 2/3rds of the Income Reserve that Arb calculated. Also note that the deficit is still accumulating at a significant rate in the first case, so 1.8 years of Income Reserve may well not be enough. With the initial 10% Safety Margin, it's 1.2 years of Income Reserve and is also probably not enough: the deficit is also still accumulating, but at only about half the rate - and at the current rate, will take another 6 years or so to reach the first example's 1.8 years of Income Reserve.

Another 10% Safety Margin, for 20% total, would make about the same differences again - so the deficit would be up to around 0.6 years of Income Reserve, and would have more-or-less stopped accumulating after 3 years.

Of course, that 20% safety margin is an extra 0.2 years' worth of required income each year, and at a yield of 5% at the time of purchase costs you 20 times that in extra capital, i.e. 4 years' worth of required income. Against that, 1.2 years of Income Reserve ceases to be needed, so the 20% Safety Margin route costs 2.8 years more of required income than the 0% Safety Margin route. What you get for that is that at the end of 7 years, the 20% Safety Margin route has stopped haemorrhaging Income Reserve four years ago, while the 0% Safety Margin route is still doing so at a fair rate...

The problem with Safety Margin is that it's expensive (about 20 times as much capital as the yearly benefit), but it does go on improving your position year after year after year and so is very effective in the long term. The problem with Income Reserve is that it's one-shot: once a chunk of Income Reserve is used, it's gone, and the next year will have to use another chunk. But it's cheap (only requiring as much capital as the one-off benefit) and so very effective in the short term. Having both helps one deal with a wide variety of income problems...

Gengulphus

[tjh290633]

However, in the first case, the number of units could have in all probability increased considerably if not all income was taken, which is what TJH does I think, thus the actual income would have moved at a much greater pace. So that case A and case B are not directly comparable.

Jon

Certainly at that time I was reinvesting some dividends, but 2008-09 was a significant anniversary and so I withdrew quite a high proportion of them in that year, 65% as it happens. In 2009-10 it was 58%, nothing in 2010-11, 33% in 2011-12, 57% in 2012-13 and 49% in 2013-14, which was the last time.

Consequently the effect of buying more units at lower prices is less than it might have been. However the change in cash dividends received is more significant:

Code: Select all

Tax Yr   Change in
         Cash Divs
2008-09  10.95%
2009-10 -46.28%
2010-11  42.12%
2011-12  23.23%
2012-13  23.70%
2013-14   9.48%
2014-15  11.85%
2015-16  -5.51%
2016-17   5.91%


and so by 2012-13 the dividends received had exceeded the 2008-09 level. That includes special dividends paid.

TJH