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Welcome

Thanks for finding my new site, focusing on FIRE (Financial Independence/Retire Early) for Americans who live in the UK, or want to.

This site grew out of an idea that I had after helping a number of people on both Facebook and Reddit. There is lots of information out there about how to invest for FIRE, and tons of information on both US and UK taxes, although somewhat less on how the two systems interact. It’s really hard to find something that ties it all together, and that’s really important for US citizens in the UK. Investing in a way that isn’t tax efficient can be hugely punitive (55%+ tax rates, massive fines for non-compliance with unexpectedly complicated tax filings, etc.).

I started putting a document together to summarize the basics of what you need to know. Once that document reached 40 pages (!), I realized I needed to either write a book or create a better site for it. That’s this site.

Next Steps

For starters, I’ll be moving the content from that initial document here, organizing and expanding. Those topics include:

  • Summary of each account option for investing (pensions, ISAs, IRAs, SIPPs, etc.)
  • High level review of real estate, inheritance tax, things to consider before you move, and the US/UK tax treaty

From there, I’ve got some ideas about other topics I’d like to explore, and will also post on more timely topics as they come up. I’ve started a list on this page – definitely welcome your comments on other topics you’d like to see!

Interactive Brokers ISA – A New Option?

I saw on Reddit yesterday that Interactive Brokers now offers an ISA. Potentially, this could be exciting news, opening up a new ISA option for Americans in the UK. Why? Because IBKR is both a) generally very low cost and b) friendly to US citizens outside the US. I already have Roth IRAs with IBKR (will write up that experience soon), so consolidating my ISAs there could be interesting.

So I thought I’d do a quick comparison with my current broker and usual recommendation for Americans in the UK, Hargreaves Lansdown. Cutting to the chase: it’s not clear to me yet if IBKR is a better option than HL, but at least it’s good to have other options coming – competition can only help. I can’t do anything until the new UK tax year on 06Apr anyway, so will see how things develop over the coming months before making any changes.

Costs & Fees

IBKR and HL take very different approaches to their fee structures:

  • HL is fairly simple, but can be pretty expensive:
    • Dealing: £11.95 per trade, but purchases can be brought down to £1.50 using the Monthly Savings feature (also tapers down if you have 10+ trades in the previous month, but you probably want to avoid that kind of active trading)
    • Dividend Reinvestment: 1%, with £1 minimum and £10 maximum
    • Platform Fee: 0.45%, capped at £45 per year (assuming you hold individual stocks, which is your only real option as a US taxpayer to avoid PFICs)
    • Currency Conversion: 1% up to £5,000, tapering down to 0.25% for over £20,000
    • Withdrawals: no fee
  • IBKR fees and commissions are generally low, but horrendously complex:
    • IBKR generally offers a Tiered and a Fixed fee option – Tiered is almost always cheaper, but it’s not clear to me if Tiered will be an option for ISAs
    • On Fixed, it’s £3/€3/3 CHF/3 USD for all trades on European exchanges up to £6,000/€6,000/10,000 CHF/$8,000. Trades bigger than that are 0.05%. For US exchanges, it’s at least $1 per trade (or $0.005 per share, if that’s higher, up to a maximum of 1% of trade value).
    • On Tiered, for European exchanges it’s 0.05% of the trade, minimum of £1/€1.25/1.50 CHF/$1.70. For US exchanges, it’s $0.0035 (~1/3 of 1 cent) per share, minimum $0.35, max 1% of the trade value.
    • Dividend Reinvestment: charged the same fees as other transactions. Automatic reinvestment is only available for US and Canadian stocks, other stocks would have to do it manually.
    • Platform Fee: £3 per month minimum activity fee. Either you pay at least £3 in commissions for trades, or you get charged a £3 fee (or the difference, if you have some commissions but less than £3).
    • Currency Conversion: 0.03% – best on the market that I know of
    • Withdrawals: One free per month, £7 after that – should never need to pay this if you plan ahead.

A couple of illustrations:

  • Buy £1,000 of a UK-listed individual stock, like part of a pseudo-indexing portfolio:
    • HL: £1.50 if you plan ahead using Monthly Savings
    • IBKR Fixed: £3
    • IBKR Tiered: £1 (the minimum, since 0.05% of £1,000 is less than £1)
  • Buy £20,000 of a US-listed stock, like if you decide Berkshire Hathaway is close enough to a diversified mutual fund that you put everything there:
    • HL: £11.95 dealing fee (I can’t find any US stocks on the list for Monthly Savings) plus currency conversion fee of £137.50 = total £149.45
    • IBKR Fixed: £20,000 buys you about 85 shares of BRK.B. At $0.005 per share, that’s less than the $1 minimum, so it’s $1. Add 0.03% currency conversion of £6 = total about £6.75
    • IBKR Tiered: At $0.0035 per share, this is just under the $0.35 minimum, plus the same £6 currency conversion = total about £6.26
  • One year of my pseudo-indexing approach of 20 UK stocks purchased in one month, assuming 40 dividend payments a year:
    • HL:
      • Dealing: 19 stocks at £1.50 using Monthly Savings, plus 1 stock at £11.95 to soak up the unused cash = £40.45
      • Platform: £45 a year
      • Dividend Reinvestment: 40 dividends x £1 each = £40 (in practice will be a bit less, since not every dividend will be big enough to buy a full share)
      • Total: £125.25
      • When you eventually sell (far in the future!), it’ll be £11.95 per stock, or maybe a bit less if you have enough transactions to move down the dealing fee table. That’s £239 future cost, although could be spread across many years of contributions.
    • IBKR Fixed:
      • Dealing: 20 stocks at £3 each = £60
      • Platform: £3 per month, one month this is covered by the dealing fees, so 11 months = £33
      • Dividend Reinvestment: 40 reinvestments x £3 each = £120 (also going to be less in practice like HL)
      • Total: = £213
      • Future selling fees: 20 stocks at £3 each = £60
    • IBKR Tiered:
      • Dealing: 20 stocks at £1 each = £20
      • Platform: same as Fixed = £33
      • Dividend Reinvestment: 40 reinvestments x £1 each = £40 (again, going to be a bit less)
      • Total: £93
      • Future selling fees: 20 stocks at £1 each, or maybe a bit more if the value is high enough to exceed the minimums = call it £60 for argument’s sake

In summary, for regular pseudo-indexing in UK stocks, if IBKR Tiered is an option, it’s moderately cheaper than HL (£30ish a year), while Fixed is a bit more due to the higher dealing fees. But if you want non-GBP stocks, IBKR becomes dramatically cheaper, on either Fixed or Tiered, due to the far lower currency conversion fee. Also, if you want to trade actively, instead of using Monthly Savings, the HL dealing fees skyrocket and either IBKR pricing scheme is much cheaper.

It is clear you generally wouldn’t want ISAs at both, or you get stung by both the £45 and £36 platform fees every year, so you need to pick your poison.

Investment Options

IBKR is known for good margin rates and options, but within an ISA they only allow:

  • Shares
  • Securities issued by Companies
  • Recognised UCITS
  • Depository Receipts, American Depository Receipts and American Depository Shares

Due to PFIC and MiFiD/KID rules, that will mean it’s just individual shares for US citizens, same as Hargreaves Lansdown. No difference here that I can see.

Customer Service

This is one I can only describe from other people’s anecdotes, so take with a big grain of salt – I haven’t had to use customer service with either company yet.

HL has a generally good reputation for customer service, being known as a relatively high-fee, high-touch broker. It’s help documentation is generally clear and concise.

IBKR has a generally poor reputation for customer service, as a low-fee broker. They enable some very complicated things (especially outside ISAs), and expect their customers to be knowledgeable about what they’re doing. They have extensive help documentation, but it’s not always that clear. I’ve heard their phone support isn’t all that helpful.

Overall Experience

The experience of each aligns with their customer service. HL is a slick-feeling website and app, nicely laid out, generally pretty intuitive. IBKR’s user interface feels about 20 years old, it’s not always easy to find where to go to do what you want to do, but the capabilities are all there somewhere and it’s quite efficient once you learn it.

I would not recommend IBKR for somebody who is brand new to investing, it’s intimidating at best and possibly an error trap. HL makes it easy for new investors, although US citizens need to be careful because they won’t stop you from doing things that are legal but have horrific US tax consequences.

What Next?

I’ve already used up my 2021-22 ISA allowance, so I can’t do anything right now anyway. But I will be keeping an eye on any user reports on IBKR ISAs, especially to confirm if Tiered pricing is an option. If Tiered is an option, it’s certainly worth thinking about, although whether the hassle of moving existing investments is worth the modest £30 a year savings is an open question – you also buy into a tiny marginal hassle of doing manual dividend reinvestment. There doesn’t appear to be any fee with HL or IBKR for a transfer of stock, but I don’t know how much pain it will involve.

If any of you decide to open an ISA with IBKR, I’d be very interested in your experience!

S&S ISA Experiment – December 2021

Now that the London market has closed for the year, it’s time for another update on my S&S ISA experiment – no huge changes since September 2021, but good to look back on 2021 and see how it’s gone.

Very quick background – because of the PFIC limitations in holding index funds in an ISA, I’m trying a mostly “pseudo-indexing” approach in my and my wife’s ISAs, buying 40 individual stocks in the hopes of approximately matching the performance of the FTSE 100. They’re all UK listed stocks, avoiding foreign currency fees from Hargreaves Lansdown and any dividend withholding headaches from US stocks.

A couple small updates since September:

  • We’d already maxed out our ISA allowances for 2021-22, so no new contributions, just holding the same 40 stocks in our S&S ISAs and seeing how they do.
  • I changed the source of the monthly account fees (0.45%, capped at £45 a year, so £3.75 a month) from within our ISAs to newly opened taxable brokerage/general investment accounts (GIA, what HL calls a “Fund and Share Account”). This means that we keep £45 more a year within the ISA wrapper. For the moment, I just put £50 cash in the GIA, but am going to purchase £1,000 of two new stocks in each of them in January, in the hopes that the dividends will pay that £45 fee in perpetuity. This is a miniscule optimization, but there’s no downside so why not?

Performance Update

Honestly, aside from adding a few more months to the graphs below, there’s been very little change here since September. We’re still very close to the FTSE 100, so no complaints. Overall, if we’d put our money in a FTSE 100 ETF (CUKX), it would have grown 5.3% since we started our ISAs, which matches our actual performance (within £14, assuming equal fees).

Definitely more noise month to month, although by the end of December they’ve come together closely:

The performance of individual stocks is still all over the place, despite averaging out to something practically identical to the FTSE 100:

Is an ISA worth it?

The big question – after 9 months (a short trial in investing terms!), is an ISA worth it for a US citizen in the UK? Quick rundown of the pros and cons:

Advantages

  • UK tax-free dividends: you’ll never pay UK tax on dividends, while in a GIA, you’d pay tax on anything above the £2,000 annual allowance. You “only” need about a £50k ISA balance before this starts to matter.
  • UK tax-free capital gains: you’ll never pay UK tax on capital gains, while in a GIA, you’d pay tax on anything above the £12,300 annual allowance. In practice, the allowance is generous enough that this is pretty manageable, but it could be a significant benefit for very large balances.
  • Deeper awareness and understanding of investing: this is a double-edged sword, but I certainly feel like I’ve learned more about investing, the companies I’m invested in, and the broader British business world. It’s also fascinating, to me, to see the vastly disparate performance of individual companies, which averages out to something more modest in an index fund. You could see this without having any skin in the game, but that certainly helps drive interest.

Disadvantages

  • US taxable dividends and capital gains: compared to a GIA this is a wash, but clearly a disadvantage compared to a pension or IRA.
  • No indexing: this one is difficult to quantify, but there is clearly an increased risk of underperformance (or overperformance!) due to being invested in a smaller number of companies. Even just compared to the relatively small FTSE 100, that’s 2.5x more companies than the 40 in our ISAs. Compared to something like a total world ETF (Vanguard’s VT, for example), that’s 9,289 stocks compared to our 40 – not even close. So far, I feel reasonably comfortable that my performance isn’t going to dramatically diverge from the FTSE 100 in normal circumstances, but if the next Amazon/Apple/Tesla is a UK company that we haven’t bought in our ISA, there could be a much more significant divergence.
  • Skewed asset allocation: this is a constraint of how I have personally implemented my ISA, picking only UK stocks. This is for what I think is a good reason, avoiding currency conversion fees and dividend withholding headaches on US stocks, but it does mean that I’m overweight UK in my overall portfolio. I’m ok with a modest UK home bias, but not everyone will be. You could buy other country stocks too, but will have an even harder time mimicking a bigger index with only 20 stocks. You could buy more stocks, but the fees add up and each holding winds up tiny.
  • Higher fees: £45 a year for each account, plus £1.50 for regular investing, £11.95 for on-demand dealing, 1%/min £1 for dividend reinvestment – it all adds up. Managed carefully, I can keep it around £125 a year per account, but that’s a lot more than the 0.08% you might pay for an index fund for an account with a modest balance (£16 on a £20k balance at 0.08%). However, if your account value is north of about £150k, you might actually save money compared to an index fund. If you do any sort of active investing, the fees add up really fast – not recommended.
    • If you’re curious, that £125ish a year breaks down as:
      • £45 account fee
      • 19x £1.50 for regular investing (£1,000 for 19 stocks, once a year) = £28.50
      • 1x £11.95 for the 20th stock, using up the “leftover” cash from the other 19 (if you contribute £1,000 but the stock price is £19 a share, you get 52 shares and £12 change – add up all that change and you’ll want to buy something with it rather than sitting there at 0% interest)
      • 40x £1 dividend reinvestment fees (2 dividends per year, per stock) – this is technically a 1% fee, min £1 and capped at £10 per reinvestment, but none of my individual holdings are nearly big enough yet to throw off more than £100 per dividend = £40.
        • In practice it’s slightly less because a) not all the stocks pay dividends and b) if a single dividend doesn’t reach the £10 threshold for HL to reinvest, it just stays in cash until the next dividend, so only £1 to reinvest 2 dividends.
      • Total: £125.45
  • Bookkeeping: keeping track of the purchases of 40 stocks and their dividends is more work than just buying one index fund with a few dividends a year. It’s not unmanageable, and HL’s records are pretty easy to use plus an Excel sheet, but it is a bit more work. If you were being efficient, you could probably get this down to an hour or so a year. For me, it’s now a part of my normal monthly financial updates, so a few extra minutes a month.
  • Deeper awareness and understanding of investing: seeing the sausage being made isn’t for everybody! If you’re the kind of person who will be upset by a 50% fall in an individual stock, and especially if you’d then be tempted to sell it, this is a real danger. Could also tempt some into stock picking and active investing – an ISA really isn’t the place for it due to the transaction fees and US tax. If you want to do active investing, a Roth IRA makes a lot more sense.

Quantifying the tax benefits

I did some quick modeling of the tax benefits. For a basic rate taxpayer, with UK dividend tax at 8.75% (from 06Apr22) and a 0% US dividend tax rate, you need to get annual dividends above the £2,000 UK dividend allowance before an ISA makes any difference – otherwise, a GIA is exactly the same from a tax perspective, and slightly lower fee (HL doesn’t charge the 0.45%/£45 account fee for a GIA). Assuming a 4% dividend yield, you have to get to a £50,000 balance before you save a penny. But get to £100,000 balance and you’re saving £175 a year on dividend tax (all UK – assuming you stay in the US 0% qualified dividends/long term capital gains rate).

The math works out similarly for a higher rate taxpayer, with UK dividend tax at 33.75% and US at 15%. Up to £50,000 at a 4% dividend yield, you’re under the UK dividend allowance, and paying US dividend tax at £300 a year – but if the money was in a GIA, you’d be paying the same US dividend tax on that, too. Above £50,000, you’d start paying UK dividend tax in a GIA, but since the UK rate is higher than the US rate, you’d have enough passive category foreign tax credits to offset all of the US tax on the dividends above £2,000 – note that you would still be paying the £300 US tax on the first £2,000 of dividends, since it’s not UK taxable. In an ISA, there’s no UK dividend tax so you’re just paying the US 15% on all the dividends. At £100k, you’re saving £375 a year on dividend tax in an ISA compared to a GIA, and it only goes up from there

Quick math: that’s £4k a year in dividends. For the GIA, first £2k is only US taxed at 15% = £300. Second £2k is UK taxed at 33.75% = £675. US tax on the second £2k is fully offset by FTCs. So total of £975 tax in a GIA. In an ISA, it’s US tax only on the full £4k of dividends at 15%, for £600, £375 less than the GIA).

In summary, if you expect your account balance to get above about £50k, an ISA will probably save you money every year on dividend taxes. Not massive amounts unless you have a big ISA balance (to save £1k a year in tax, you’d need an ISA balance of almost £200k), but if you saved £20k a year for 5 years and then stopped, over 30 years you’d pay about £49k in dividend taxes in an ISA, and £120k in a GIA with the same investments (assumes 4% dividend yield, 3% capital growth, reinvested dividends, higher rate taxpayer). The extra fees in the ISA would add up to a few thousand GBP, but you’re still well ahead of a GIA, less than half the taxes and fees.

Capital gains is tougher to model, and realistically I think most people would be able to stay under the £12,300 annual allowance by careful management with tax-loss and tax-gain harvesting, especially if also supplemented by Roth contributions or other pre-pension investments. But it’s there if you need it, and you might also be able to stay in the 0% US long term capital gains bracket, for a total of 0% on capital gains tax.

So what?

All that said, is an ISA worth it? Honestly, it’s probably marginal for most people. There are tax savings to be had, but it has risks due to reduced diversity and it does add complexity. It’s pretty clear an ISA is not worth it in these situations:

  1. A pension/SIPP is far more tax efficient, so all your investment intended for ages after pension access age is better in a pension (at least up to the Lifetime Allowance). ISA only makes sense for money you need before 55/58/whatever.
  2. A Roth IRA is also clearly more tax efficient, since it’s recognized by both the US and UK, and you can withdraw the contributions at any time, helping with the bridge from early retirement to pension age. There will be exceptions, but in general I would recommend maxing out a Roth IRA before touching an ISA.
  3. If you aren’t comfortable with the additional risk and complexity that comes with individual stocks, accept the tax hit and use an index fund in a US brokerage account (assuming you can get/keep one, possibly using a US address).
  4. If you plan on moving back to the US, an ISA probably isn’t worth the faff. You won’t care about the UK tax advantages once you move back, and there are no US advantages.

So who is an ISA good for? Assuming you’re a US citizen in the UK, of course:

  1. You expect to be able to get above £50k-ish in your ISA in fairly short order (e.g. max the ISA for 3 years), where the UK dividend tax advantages start to matter OR
  2. You aren’t able to get non-PFIC index funds in a GIA, so you’re forced into individual stocks anyway (for example, your brokerage enforces the MiFid rules preventing you from buying US funds and you’re unable to open a different one, unable to use a US address, etc.). If you’re going down the individual stocks pseudo-indexing route anyway, the only downside to an ISA vs something like Interactive Brokers is the higher trading fees. If you’re just doing buy-and-hold investing once a year, plus dividend reinvestments and the account fee, you can keep this close to £125 a year, which is offset by the dividend tax savings once you hit a £70k-ish balance OR
  3. You’re an investing nerd and want to optimize every tax efficiency you can, and find watching the sausage being made interesting more than scary.
  4. AND you don’t mind the extra bookkeeping, the pseudo-indexing reduced diversification, and potentially the impact on your asset allocation.

I’m in buckets 1, 3, and 4, so I plan to continue with my ISA investments. I’ll move cash from Premium Bonds to our ISAs in April (and rebalance with G fund bonds in my TSP, to keep overall equities vs cash+bonds allocation in balance) and invest in the same 40 companies again. Keeping to the same 40 companies also means the dividends will double, which increases the efficiency of dividend reinvesting by reducing the number of £1 reinvestment fees I pay compared to having 80 companies. For me, I’m happy with the ISA wrapper as a supplement to my core investments in my UK pension and Roth IRA, plus legacy investments in my TSP, but it’s not for everybody.

2021 Year in Review

I always find the end of the year a good time for reflection, on the past year and the upcoming one. It’s a bit of a transition time for many of us – I certainly had a bit of a mad rush to the end of the year at work (which happens every year, and yet none of us have learnt how to prevent it!), and am feeling a bit of a relaxed “sighhhhh” as I sit here on Christmas Eve. So without further ado, some of my highlights of 2021 and thoughts for 2022:

Another year of not quite normal

I won’t dwell on COVID, but certainly this has not been a normal year for any of us. Starting the year in a prolonged, tapered lockdown with kids not going to school wasn’t anybody’s idea of fun, but we got through it. I started a new position at the same employer that’s permanently 100% working from home aside from (eventually) some travel, so this “temporary normal” really is becoming my “new normal,” at least from a work perspective. I’m very fortunate to have half of a summer house as my office, making it relatively easy to separate work and home, even if my commute is just a few steps out the back door and across the garden. The flexibility and lack of commute is certainly nice, although the dark side, especially in a global role, is that I have done a lot of early mornings and late nights to work with colleagues in Asia and the US. Better than hopping on a 12 hour flight just to spend a week in a conference room, at least.

I did do two quick business trips to the continent before Omicron put a stop to that. It was a strange experience actually seeing colleagues in person, including some people I’ve been working with for years but never physically met. It was nice to get out, and I am looking forward to a bit more travel next year – there’s a happy balance to be struck, I think.

On the family front, having two young kids certainly fills our days! The girls are wonderful, albeit challenging at times. The older one has adapted to COVID school life, and having a full, uninterrupted autumn term has been good for her. COVID pre-school is all the younger one has ever known, which is a bit sad but they have a good system. I wish we saw our extended family a bit more – some of that is hazards of the expat/immigrant lifestyle, but we’ve missed out on trips that would have happened otherwise, and at this point my dad hasn’t seen our younger daughter since she was about a month old, more than 3 years ago. Hopefully in 2022!

I started this blog

Some of you know that I’ve been pretty active on Reddit and Facebook groups related to investing, FIRE, Americans in the UK, and so on, and this blog grew out of an idea for an investing flowchart for Americans in the UK, due to all the special challenges we face. I couldn’t really find a place to host it, so I started with a Google Doc that eventually became the foundation of this blog, the flowchart and all the account descriptions.

I’m enjoying this medium as somewhere I can go more in depth – maybe in ways that are a bit self-indulgent, if I just get interested in something and want to explore it. But it’s my blog and I get to do what I want 🙂 That said, I appreciate all of you reading this, and very much welcome suggestions on what I should explore next, beyond the suggestions some of you already provided. I won’t guarantee I’ll get to all of them – some things I just don’t feel qualified to cover in much detail where I have no direct experience and they’re particularly complex, stuff like buy-to-lets, defined contribution pensions, estate planning beyond the basics, etc. But I’m mostly up for learning!

I did initially include some ads on here, figured I’d at least try to cover the hosting costs. But the ads I saw were all very low quality, and I made a total of 6 cents before I stopped them. I might revisit that in the future, but for the moment I’m happy to count this as an inexpensive hobby, rather than having rubbish ads cluttering up the space.

Next year, I do want to spend some time making the blog look and function a bit better. Nothing too extreme, just make it a nice experience, easy to find things, that sort of stuff. If anybody happens to know a good resource for learning how to do that, I’d appreciate the recommendation, or I’m sure I can figure it out with Google and YouTube.

Staying the course (mostly)

I’ve done LOTS of thinking about investing this year, especially on asset allocations and eventual withdrawal plans. End result is something not all that different from where I started, just with better clarity and a few small tweaks:

  • Decided that I will consider bonds & cash as a single asset category, starting at 21% and going up 1% a year. Adjusted my asset allocation to match, which meant a slight move into US and UK government bonds (TSP G fund and a gilt fund in my UK pension, plus pre-existing series EE bonds and cash, largely in Premium Bonds).
  • Within equities, I am essentially purely global market cap with a modest UK home bias. That home bias is largely driven by the ease/cheapness of having only UK stocks in my ISA. So my equity allocation winds up being market cap across all my investments except my ISA, and then some extra UK in the ISA. That feels about right – a little home bias makes some sense, and it’s practically more feasible than trying to match a global index with individual stocks

Aside from asset allocation, I’ve done my usual contributions plus started my ISAs:

  • Matched the maximum employer match in my UK pension (8% from them, 8% from me). This feels like the right balance for tax efficiency and ability to bridge from early retirement to pension access age. I may bump up those contributions a little next year, depending how year-end bonuses look, to try to stay out of the 63.25% tax rate, which is just horrifying!
  • Maxed out Roth IRAs for me and my wife
  • Maxed out ISAs for me and my wife, as part of the ISA experiment. A good chunk of this was a move from cash/mortgage debt, not out of income. I’ll post a separate end of year update on my ISA experiment.
  • Some small taxable investments, just fleshing out asset allocations to make best use of cash, bonds, & equities. Some of this was in a new Interactive Brokers account, which has also been a small, successful experiment (with more to come with a Roth IRA in UCITS ETFs early in 2022).

I also continue to allow myself up to 5% of fun money, for individual stocks, crypto, whatever. I unashamedly put a small amount into meme stocks like Gamestop and Blackberry – they’ve bounced all over the place, some are up and some down as of today. Takes care of FOMO without risking significant money. I dabble slightly with some biotech stocks too, since I’m in the industry – these have done better than the meme stocks, though nothing life-changing. All together, while I “allow” myself 5%, these add up to just under 1% today, and that’s fine. I haven’t done any crypto yet, but haven’t ruled it out, either, as part of that fun money.

Financial performance

In harder numbers, 2021 was good – topline net worth is up 15%, of which about 10% is new contributions from income and 90% is investment growth, for a 13.5% investment growth. That’s not entirely suitable for investment comparisons, because just under 1/3 of our net worth is tied up in the house, and I’ve only assumed a very conservative 5% increase in our house value since purchase 2.5 years ago. I tend to be conservative with house equity, especially given transaction costs and the challenges in valuing a one-off asset. But given where we are, in the countryside but commutable to London, it’s easy to imagine a much higher appreciation.

So for better comparison, if I exclude home equity and only look at equities and bonds+cash, I get:

Personal Performance17.7%
All World Equity Tracker (VWRP)19.3%
FTSE 100 (CUKX)15.7%
S&P 500 (VUSA)24.4%
LifeStrategy 80%14.6%
All using accumulation funds to include reinvested dividends

That all sounds pretty consistent – VWRP beat me due to being 100% equities compared to my 79/21 split, but I’m a bit higher than LifeStrategy 80 because I don’t have as large a UK bias as they do, and the UK underperformed the US. Obviously this year would have been a great year to be 100% US large cap growth (up 30%+), but hindsight is 20/20 🙂

I do see a lot of people advocating stuff like that: 100% equities, all in the S&P 500 or Nasdaq, maybe with some margin, options, tilts to tech, and so on. That scares me a bit, and makes me worry we may finally be nearing the top of this long bull market, but I could also see it running for a few more years.

  • My Boglehead side says “stay the course” and “buy the haystack”
  • My Buffet/value investing side says “be fearful when others are greedy” and “only when the tide goes out do you discover who’s been swimming naked”
  • I’m sticking with my mostly market cap based approach, but buying more modestly priced UK equities in my ISA doesn’t feel bad, either, and keeping my strong 40%ish ex-US position is also comforting. And if things do go down and equities fall under their rebalancing thresholds, I’ve got plenty in bonds+cash to rebalance into cheaper equities.

How close is FIRE?

That growth and ongoing contributions puts us at about 64% to our FIRE number – that’s paying off our current house and 25x annual expenses (4% safe withdrawal rate). I do track our spending vs a general budget – there’s not really active work to stay within a specific budget at this point, more to observe and have confidence that our FIRE spending plan is realistic. We’re within £1,000 of our annual expected spending, depending how this last week of the year works out, so that still feels right, but will definitely keep an eye on our spending given the recent inflation numbers.

At the beginning of the year, we were 55% to FI, so 8% improvement is very good! If we could keep up 8% closer every year, we’d hit our FIRE number by 2026, well ahead of plan (more conservative projections show 2032, and my real goal is financially FIRE-ready by 2036 when the younger one turns 18). If we were to actually hit our number a decade earlier, that’d obviously be great and we would need to rethink some things (in a good way!), but I will also be pretty surprised if we don’t have some kind of a bear market in the next 5 years, or even just flat for a while.

Looking back, we were at 45% to our current FI number when we moved to the UK in 2018. I was worried how the significant pay cut would impact our FIRE path, but the pretty tremendous performance by the markets has more than offset that, and a few lucky opportunities at work have pushed our savings rate to be not too far off where it was in the US. And the impact on quality of life has been very positive, so definitely a net win.

I set up the projection below back in August 2020, using a 5% real growth rate along with my then-current pension contribution rate. It’s not showing % to FI, but % to my liquid net worth goal – as if I paid off my mortgage today, how much more would I need to hit my FIRE number. While the pension contribution rate has gone up slightly, the big difference between the plan and the actual has been investment growth:

Linear doesn’t actually make any sense for growth, but the exponential feels wildly optimistic…

Net worth isn’t quite so dramatic, since it goes back so much further, but telling the same story:

“Accounts” is cash net of credit cards, “Loans” is just my mortgage, “Invest” is what it says on the tin. Top of the graph is my FIRE number.

Goals for 2022

A few things I’d like to do for 2022:

  1. Financially, stay the course. Keep going on pension contributions, max out ISAs and IRAs again, and maybe some small taxable investments. The approach has worked very well so far (the last 14 years or so), and there’s no reason to change. Even knowing how highly valued the stock market is today, especially in the US, I have faith in my diversified allocation over the long term.
  2. Personally, I want to keep working on my work/life balance. This year has been a bit of extremes – when I first started the new role, I had plenty of “life” time. But the second half of the year really ramped up, and “work” took up too much. There’s a happy middle there, and I’d like to spend more time in that middle. I am starting another new position next year, taking over from somebody who is retiring. He’s a bit of a workaholic, so that’s something I want to change for myself and for the people in my new team.
  3. And I’d like to make sure to take time and attention to my own fitness. I’m heavier than I’d like to be and don’t get the exercise I should. It’s just a matter of making time for it and being a bit more attentive – not looking to make a drastic lifestyle change, but nudges in the right direction that work over time – just like in investing.
  4. Aside from cleaning up the design and layout, I don’t have any major goals for this blog. I write because I enjoy it and want to help other people in similar situation. I’m happy to reach as many people as I can, but realistically, there’s something in the neighborhood of 200,000 Americans in the UK, and only some fraction of them are going to be interested in this stuff, plus a chunk more interested in moving here. Optimistically, that’s maybe a few thousand interested readers – I appreciate all of you, but I’m also not going to be turning this into a business, so I’ll do what is fun for me 🙂

How has your 2021 been? Where do you want to focus in 2022?

And of course, thank you for reading this year, and I wish you all a happy Christmas and a brilliant New Year! I hope you all enjoy some time with your families and have a chance for some relaxation and reflection.

Bridging to Retirement – Splitting SIPP & ISA Contributions

Edit 06Dec21: I realized that this is all completely wrong! You can get the same effect, without paying National Insurance, by just putting part of the money to the pension, then taking the 62% hit on the take home cash for an ISA.

For example, for £1,000 of pre-tax income, put £475 in your salary sacrifice pension. Pay 62% tax on the £525 remaining, for a take home of £199.50 – then put that in your ISA. That’s £674.50 invested and £325.50 in tax – 32.55% effective tax rate, better than the 33.5% if you use a SIPP. In retirement, that’s £199.50 you can access anytime and £403.75 (after 15% tax) from your pension, total of £603.25, for a 39.675% effective tax rate.

I’ll leave up the original, because the overall analysis of pension vs ISA is still valid – all the numbers just tilt slightly lower the pension you use because you save NI. But avoid all the hassle of a SIPP and just salary sacrifice. Sorry!

Original Post: This will be a fairly nerdy post that only applies to a small niche – fair warning! But if you’re interested in early retirement, the personal allowance taper, and/or the lifetime allowance, it might be interesting. I’ll also note this applies just as much to non-US citizens, nothing US specific here, it’s all UK rules.

Three common topics come up in UK FIRE circles:

  1. How to “bridge” from early retirement to the age where you can access a workplace pension and/or SIPP (currently 55, changing to 57, may well go up more in the coming decades).
    • For readers familiar with this discussion in US FIRE circles, the UK situation is complicated by the fact that there is realistically no way of accessing a pension early, barring terminal illness (which kind of defeats the point…). This contrasts with Roth ladders, 72(t) SEPP, etc. for the US. But at least ISAs have no age limit at all!
  2. How to avoid the 62% tax trap between £100k and £125,140
    • That’s 40% income tax, 2% National Insurance (rising to 3.25% next year, for a 63.25% marginal rate), and the Personal Allowance reduction of £1 for every £2 of adjusted net income over £100k, such that the £12,570 allowance drops to zero at £125,140 income.
    • In simplified terms, Adjusted Net Income is your total taxable income (wages, interest, dividends, self-employment profits, some benefits, some rental income, etc.), minus pension contributions and gift aid donations.
  3. How to avoid exceeding Lifetime Allowance (LTA) and paying the 25% penalty on a total pension value exceeding £1,073,100.

As a general rule, it is more tax efficient to make pension contributions than ISA contributions, due to the relief of income tax on pension contributions, plus the NI relief if it’s a salary sacrifice pension. Nothing I’m going to say changes that – the best way to keep as much of your money as possible is to salary sacrifice it into a pension – and you should always* take advantage of any employer match. That’s even more true at the 62% marginal rate – you can either put £1 in a pension or take 32p home and stick it in an ISA (or a taxable General Investment Account, GIA).

However, if you’re concerned about building an early retirement “bridge” and/or about exceeding the LTA, you want to think about how to manage both pension and ISA/GIA contributions to meet those objectives – basically, how to reduce pension contributions but not let HMRC take too much of your money.

*Somebody will find an edge case where you are better off without an employer match, but it’s extremely rare.

SIPPs vs Workplace Pensions

SIPPs and workplace pensions are very similar. But there are a couple of key differences that matter here:

  1. When you salary sacrifice into a workplace pension, 100% of your sacrifice goes into the pension. £100 sacrificed = £100 in your pension, no tax withheld.
  2. But when you contribute after-tax dollars to a SIPP as a higher or additional rate taxpayer, the situation is a little funky:
    • Your pension provider provides the first 20% of tax relief to you directly in the SIPP, increasing your contribution by 25% (20% tax on £125 is £100, so if you contribute £100, they’ll top up to £125)
    • To get the remaining tax relief – which could be another 40% if you’re a higher rate taxpayer in the Personal Allowance phase out – you need to ask HMRC, typically via a Self Assessment (if you’re not otherwise required to file a Self Assessment, you can just contact them for the refund – you’d have to get your net adjusted income completely under £100k, since that’s one of the triggers for filing a Self Assessment).
    • When you get the tax relief back from HMRC, it’s cash – not deposited to your SIPP, just real money in your current account. You could choose to put that cash in your pension (and then get more tax relief next year, since money is fungible and that cash could effectively come from after-tax income), or you could put it in an ISA or GIA. This cash is the key difference between a SIPP and workplace pension, for our purposes today.
  3. Also worth noting that salary sacrifice saves you NI, while a SIPP doesn’t allow you to claim the NI back. Only 2% (to 3.25%) for higher and additional rate taxpayers, but it’s money that’s gone for good.

Splitting After Tax Cash to SIPP & ISA

Given what we know about getting cash tax relief on a SIPP, this opens an interesting possibility. Let’s compare three scenarios – we’ll assume your adjusted net income is within the Personal Allowance phase out, none of this makes much sense in any other bracket. For a simple example, this is all wage income and your wages minus any existing salary sacrifice pension contributions brings you in the £100k to ~£125k range:

  1. Salary Sacrifice: you sacrifice an additional £1,000 to your pension, resulting in £1,000 pension balance. In retirement, this will be taxed – let’s say a 20% tax on the 75% taxable portion, resulting in a final value of £850 (ignoring investment growth and inflation – we’ll take those as constants for all three scenarios). 15% effective tax rate.
  2. ISA only: your £1,000 of taxable pay becomes £380 of take home cash. You contribute all £380 to an ISA. The ISA is tax free forever, so that’s £380 in retirement – less than half of what that £1,000 would be worth in a pension, but you can access it whenever you want. 62% effective tax rate.
    • Reminder for US citizens: ISAs are not US tax advantaged and you should not hold PFICs in them! Individual stocks only.
  3. SIPP + ISA: take that £380 take home cash and contribute it to a SIPP. Your pension provider adds 20% tax relief, so you have £475 in your SIPP. When you file your UK taxes, you claim back the remaining 40% of tax relief (20% from your 40% higher rate band, and 20% from the Personal Allowance phase out) – that’s £190 cash. You then contribute that £190 cash to an ISA. In retirement, that’s £190 you can access anytime and £403.75 (after 15% tax) from your SIPP, total of £593.75, for a 40.625% effective tax rate (33.5% at contribution)

33% tax today plus more on pension withdrawals for a total of 40.625% isn’t great, but it’s very nearly the same 42% you pay on income under £100k, without the Personal Allowance taper. So splitting between a SIPP and ISA gets you in the same tax position as using after-tax cash in the 42% bracket completely for an ISA, but with the drawback of locking about 2/3 of it away until pension age.

A Spectrum of Options

Scenario 3 above uses all of your cash for a SIPP and then an ISA, but you don’t have to. If you want more in the ISA, you contribute less than the £380 per £1,000 to the SIPP, and put the balance in your ISA. Equally, you can save more tax by putting more than £380 in your SIPP – you’ll have to effectively borrow from yourself until you get your refund from HMRC.

You can pick any option, from 0% SIPP and 100% ISA, to 100% SIPP and -2% ISA (since you still have to pay NI, you could withdraw cash to do that – although at that point you should just salary sacrifice and save the NI).

I tried a couple ways to visualize this – the first comparing the three places that £1,000 can go: tax, SIPP, and ISA. X-axis is the amount contributed to the SIPP, from £0 (everything to tax and ISA) up to £800 (above £800 and you’re basically just taking cash/ISA to pay income tax – go for salary sacrifice at that point). Y-axis is the value in each account: SIPP, ISA, and tax (so in the Government’s account, not yours!):

There are no kinks or inflection points – the more you put in your SIPP, the less you pay in tax, and the less you can access early.

The other way to look at it is how your total investment changes depending how much you contribute to your SIPP:

Again, no kinks or inflections – the more you put in your SIPP, the more you have invested (because the less you pay in tax).

I’ll paste the same charts at the end, but with 15% tax on the SIPP balance – it doesn’t change the conclusion at all.

So What?

I’ll reiterate that the best way to reduce taxes is via salary sacrifice to a pension. That said, hopefully this shows that there is a middle ground blending a SIPP and ISA to reduce taxes to a fairly reasonable level while also making some money accessible early, and reducing the impact of the Lifetime Allowance.

I’m in the very fortunate position that, if my employer’s year-end results are good, my annual bonus will probably just push me into the 62% bracket. I will wait to see how far into the bracket I go, but I’m definitely considering the SIPP + ISA option. What do you think, is this something that might be useful to you?

Assumptions & Clarifications

Didn’t want to clutter up the body of the post, but for the especially nerdy, there are some assumptions above that might matter for specific situations, and a few nuances I deliberately ignored:

  • I’ve assumed that SIPPs are an appropriate investment for a US citizen in the UK (although everything above would also apply equally to a non-US citizen). That means it’s treated as a “pension” per the treaty and you can effectively invest in it (the “pension” designation protects any PFICs). Whether or not you need to file form 3520/3520A doesn’t affect the analysis, although it’s a pain if you decide it is required.
  • Employer match is already maxed out and you don’t get any payment for the employer portion of NI. If you haven’t already maxed your employer match, obviously do that first. If your employer contributes some of their NI, that would push the balance towards the salary sacrifice pension.
  • Real returns are the same in a pension or ISA – given the restrictions on US citizens investing in ISAs, this is a big assumption. The analysis would still hold completely true if you used a Roth IRA (with some restrictions on early access), and mostly true if you used a taxable brokerage account as long as you manage capital gains and dividend taxes (both US and UK taxes involved).
  • You’ve still got room in your ISA to contribute. If ISA is maxed, then Roth IRA or taxable GIA as above.
  • 20% income tax on SIPP withdrawals is a rough assumption. It assumes no Personal Allowance (it’s all used by State Pension, Social Security, or other income – likely to be roughly true) and that your income doesn’t push you into the 40% bracket.
  • Assumed you’re still staying under the £40k pension annual allowance, combined for all SIPP and salary sacrifice pension contributions.
  • Instead of having a refund of the remaining 40% pension relief from HMRC, you could get the refund one year and then adjust your tax code so you get the cash spread through the year, and could do ISA contributions earlier. That’s mathematically better (time in the market and all that), but more complicated if your income isn’t stable, you’ve got significant variability in bonuses, paid on commission, that kind of thing.

Charts & Data

Account balances, assuming 15% tax on the SIPP in retirement:

Total investment, also with 15% SIPP tax

And if anybody wants the spreadsheet data (easier to pick out individual values), I’ve made a copy in this Google Sheet.

November Grab Bag

Hi everybody – sorry it’s been a while, life gets in the way! Nothing bad, just been busy with family and work and nothing has really drawn me in for a full post. So I thought I’d post a few thoughts on two topics today, and some thoughts on upcoming posts.

Inflation & Investing

Most of the talk on the various finance communities I frequent seems to be some variation on “what to do with such high inflation?!?” Lots of variations on a theme: how to protect my investment from inflation, should I buy bonds with such high inflation and low yields, what should I do about an emergency fund so I don’t lose money to inflation, and so on. My thoughts:

  • First, calm down, inflation isn’t that high, when you compare to history or to other economies. 4.2% in the UK, 6.2% in the US – yes, these are big numbers when we’re used to 2% or so, but it’s a long, long way from hyperinflation. Nobody is trucking around dollars or sterling in wheelbarrows!
  • But, interest rates are also extremely low, when usually you can get a risk-free return that matches or beats inflation. The last time inflation was above 5%, in 1990, 10 year treasuries were above 8% yield – today, they’re at 1.375%. Quick graph of 10 year treasuries vs annual US inflation – the UK data I have isn’t as clean, but it’s a similar trend:
Data from NYU Stern
  • So, what to do about it? Realistically, is there anything you can and should do, now that inflation is actually here? A few of the more commonly recommend approaches include:
    • Inflation-indexed bonds/gilts are designed for to mitigate against inflation, but their yields, aside from the inflation adjustment, are practically (sometimes literally) 0%. And any bonds traded openly are subject to interest rate risk if rates rise from their current very low levels. I don’t have a crystal ball to say when or how much rates will rise, but rising inflation feels like it increases the risk of rises in the near future, and we’re seeing the market price that in with mortgage rates coming off their record lows. Plus, inflation is already here, so the higher inflation linked adjustments are priced in – I don’t see these as especially attractive, except maybe as a portion of your overall bond allocation.
    • US I bonds take away the interest rate risk, since they aren’t openly traded, only bought and sold to the US government. And the current rates of 7%+ (all of that being inflation adjustment) are clearly attractive, although that’s only guaranteed for 6 months before the inflation adjustment changes, and you’re stuck with the 0% coupon rate. The 1 year lockup, 5 year penalty on interest, and $10k annual limit don’t help, either, and as UK spenders we take on currency risk with USD investments. I think there’s a place for these, but given the limits they’re hardly a panacea for an inflationary environment.
    • Some people are recommending crypto as a store of value in an inflationary environment. Not sure I buy that crypto won’t be impacted by inflation (no historical data), but I do know the day to day fluctuations in crypto prices make me hesitant to use crypto as a safe store of value even if those fluctuations aren’t linked to inflation. I don’t want my “safe” money bouncing around that much! Crypto as a long-term investment is a topic for a different day…
From Yahoo! finance
  • For me, this is the time to stay the course. If you trust your overall asset allocation and investment policy statement, it’s designed to handle anything life can throw at it, within the foreseeable possibilities. I’m still at my 79% equities, 21% bonds+cash allocation with no intention of changing, except bumping to 78/22 next year as planned. Changing your plans just because people and the media are making a lot of noise is a good way to chase performance and lose out overall.
    • Within the bonds+cash allocation, it always makes sense to move money to the best combination of yield, access, and risk – leaving all your cash in a 0.01% high street bank account isn’t a good idea in any environment! Same if you have a dedicated emergency fund, at least get the best rate you can (probably the 1% prize rate on Premium Bonds, as of today, unless you can lock some of it up for a fix). If you wanted some of your emergency fund in I bonds, that seems reasonable, too.

S&S ISA Experiment Update

I haven’t done a proper update in a few months, mostly because the experiment is going well. I’m within a percent or so of the FTSE 100 – sometimes ahead, sometimes behind, but close. Individual investments are all over the place, with the best (M&S) up 61% and the worst (IAG, owner of British Airways) down 23%. Not through any investing acumen on my part, just my almost-random approach to a DIY index.

I’ll do a bigger update, probably at the end of the year, but so far I call the experiment a success and plan to continue my ISA contributions next UK tax year.

Upcoming Topics – Suggestions?

I keep a running list of topics I’d like to explore – some of the ones that I expect to come up in the next few months are listed below. But I’m eager to hear from you – what would you like to read? More diving into the details of IRS and HMRC publications, tax treaties, and the like? Modeling and projection? My own financial story and approach?

Some topics I might tackle in the next few months include:

  • Expanded US Child Tax Credit and what it means for Americans in the UK – they’ve made it a bit complicated this year…
  • Comparison of US tax filing tools – I’ve used TurboTax previously, just started playing around with TaxAct and I’m impressed so far. Any others you think I should try?
  • Breakdown of my 2021 taxes – I expect 2021 to be a reasonably typical year, might be a good example of what a US tax return looks like for an American in the UK
  • 2021 year in review – it’s been a good year from a personal finance perspective, at least!
  • Tools for tracking investments and FIRE in two countries, two currencies – at least the approach that works for me
  • Impact of Biden’s Build Back Better Bill on Americans in the UK, once/if it’s actually passed…

What else should I take a look at? Thanks for reading!

A Phased Approach to Emergency Funds

In my recent post on my approach to bonds and cash, I mentioned that I don’t have any dedicated emergency fund at all. I know this flies in the face of conventional personal finance wisdom, but I think I’ve got a pretty sound justification. My personal approach is not quite so aggressive as somebody like Early Retirement Now, with a 100% equity portfolio and emergencies funded through a combination of credit card float, cashflow, home equity line of credit, and a worst case equity sale. It’s not that I disagree with ERN’s logic, and I fully believe that his approach is mathematically the highest return one, but my risk appetite is a bit lower – that’s just what helps me sleep at night.

Over the years, I’ve gone through three distinct phases of emergency funds – while these might not be for everybody, I think they’re a reasonable framework for thinking about an emergency fund as you mature in your finances.

Phase 0: Crisis Finance

I’m cheating with Phase 0 because I’m in the very fortunate position that I never really went through it myself. This is where you’re living paycheck to paycheck and frequently not having enough at the end of the month, dipping into payday loans, borrowing from friends, racking up credit card debt, and the like.

In this situation, it totally makes sense to me to have a small emergency fund (few hundred £ maybe) just to smooth out the inevitable bumps in life. Clearly the main focus here is getting out of the paycheck to paycheck cycle!

Phase 1 : Dedicated Emergency Fund

This is where I was basically from leaving home through most of my 20s, and lines up with conventional personal finance advice. I was starting to invest, but most of those investments were locked away in my TSP (military 401k), not much I could call on in an emergency. So, I had a dedicated high-yield savings account I considered my “emergency fund.”

You’d want to tailor how much is in this fund to your own situation – I had a very secure job for most of this time (the Navy tends not to fire people on short notice) that also came with very good healthcare, plus relatively low fixed expenses (I was single, renting, no major loans), so this didn’t need to be a ton of money, maybe a few months of expenses. I can’t really recall having to dip into it for anything big, maybe some car repairs, but it gave me piece of mind.

Of course, if you have large fixed expenses, a “flexible” (aka unreliable) job, and/or health issues (for those readers in the US – not as much as concern if you’re in the UK with the NHS), then that argues for a substantially larger pot.

I grew out of this phase from a combination of three factors:

  1. Got out of the military and into a good job, but it wasn’t rock-solid like the Navy
  2. Bought a house, got married, had kids – bigger fixed expenses and less ability to tighten my belt
  3. Steadily growing net worth, including starting to have more money in easily accessible investments through a taxable brokerage account

Phase 2: Discrete Savings Pots

All those things happened around the same time – I don’t think any one of them alone pushed me into this next phase, and it’s kind of a fuzzy line. But I started realizing that my “emergency fund” was doing two very different things:

  1. Insuring us against a major emergency – protracted job loss being the most likely, major health spending the other primary possibility (still in the US at this point, although my insurance was pretty decent).
  2. Smoothing out irregular expenses – some of this was lumpy within a year (oil-fired heating costs a lot in the winter, car insurance paid annually, that kind of thing), and some spread over multiple years (boilers, hot water heaters, roofs, appliances, cars – all eventually need replacing and maybe irregular repairs).

Bucket #2 isn’t really an emergency, since these are things that we know will happen, even if we don’t know exactly when or how much. At this point, I had some guesstimates on what this spending looked like, and set up buckets to build up incrementally every month. For example, $250 a month to utilities, but in the summer it’s more like $100 and winter more like $400 actual spend, so the account grew in summer and shrank in winter, aiming to be just a bit above $0 come the warmth in spring. At the time, these were actual separate bank accounts, although all at my main bank. Eventually they just became lines on a spreadsheet, mostly due to moving to the UK and not wanting to deal with so many actual accounts – you could do the same thing with “pots” in Monzo, Starling, etc.

Bucket #1 was still a “real” emergency fund, but as my investments grew, I started to get comfortable with some of that fund being invested. Given my experience and the Boston area job market, I wasn’t expecting to be out of work for long, even if I was laid off or my company folded, so I was pretty ok having maybe three months of expenses in cash, and the rest accessible from a taxable brokerage account. I was doing a gut feel calculation, not too much math behind it, but figured the expected returns were worth the potential risk of having to sell in a downturn. Everybody will make a different call on this, and that’s ok!

That risk panned out for me – whether that’s luck or just good risk management, I’ll leave to you. But this was around 2015, so with reinvested dividends that money has nearly tripled since then!

I kept this approach for a good 6 years or so, until very recently. There’s no time limit on it, and I think the transition to the next phase is more emotional than quantitative.

Phase 3: Consolidated Cash & Bonds

As part of my recent thinking on asset allocation and the role of cash+bonds in my portfolio, I realized that my dedicated “emergency fund” served no real purpose. I’d actually been slowly reducing that line on the spreadsheet anyway, because my other short-term cash savings were high enough that it seemed silly to keep so much cash, but that wasn’t entirely a deliberate decision, more just gut feel.

Now, I actually have a logical basis:

  1. My cash+bonds allocation, at 21%, is already about 2.5 years of normal budgeted spending, more than any emergency worth planning for. In a real emergency, we’d cut spending back to push that well past 3 years.
    • There are “black swan” kind of events this won’t cover – if my wife and I both get injured and can never work again, say. But no emergency fund can practically insure against that – you only insure against never working again by fully achieving financial independence, and we aren’t quite there yet.
  2. My cash+bonds allocation is very safe, with extremely limited volatility
    • Mine is safer than a conventional bonds approach, with it being primarily the TSP G fund, Series EE bonds, and Premium Bonds – issued and guaranteed by the US and UK governments, with no chance of loss of capital.
    • But even if you were in 100% BND or similar, take a look at the chart and see how big the biggest drops are – absolutely tiny compared to stocks. Something like a 7% drop during the COVID drop in 2020, compared to an almost 50% drop in a US total market fund.
  3. I have good control over the non-emergency lumpy expenses. Practically, they largely come out of cashflow (via credit card float), although I’m still tracking my buckets on a spreadsheet, more for budget measurement than any sort of real concern over emergencies. They’re pretty theoretical buckets within the cash part of the bond+cash allocation, but I find them helpful to see if my budget stays realistic – since my current budget is also my expected retirement budget, it’s important that I know how much I’m spending.
  4. I have ample credit available. I’ve never needed to use it (pay off your credit cards in full every month!), but I’ve got 6+ months of normal budgeted spending available on my credit cards. Sure, not everything can go on a credit card, but combine that with the cash+bonds allocation and tightening our belts and we get to something approaching 4 years of spending before needing to touch equities.

Put that all together, and I don’t see a point in having another pot of cash labelled as an “emergency fund” anymore – that would really just tilt my asset allocation more towards bonds+cash for the purposes of semantics.

Special Considerations for Americans in the UK

Pretty much everything I said above applies whether you live in the US, UK, or almost anywhere else – only caveat being around health care expenses as a very plausible emergency in the US, but a much smaller financial impact in the UK.

A few caveats specific to Americans in the UK, though:

  • Currency risk is real, so take that into account when deciding where to put your emergency fund, if you have one, or your cash+bonds allocation.
    • It’s safest if your emergency fund is in the currency where most of your expenses are – probably GBP for most of us in the UK.
    • For the past few decades, the pound has mostly fallen relative to the dollar, so you’d actually make out to your advantage if, for example, you’d had your emergency fund in USD just before the Brexit vote dropped the value of the pound from about $1.60 to $1.20.
    • There’s no reason to think that trend has to continue though – you could easily have the pound appreciate just as your emergency happens. If that same situation were reversed and the pound climbed from $1.20 to $1.60, your USD-denominated emergency fund has dropped, in GBP terms, by a quarter. Your 6 month fund now only covers 4.5 months!
    • Personally, if I was still in the Phase 1 or maybe Phase 2 mode, I would have my dedicated emergency fund in GBP only – it’s entire purpose is to help me sleep at night, and exposing that fund to currency risk just gives you another thing to worry about. In Phase 2, if you’re starting to expose some of your e-fund to market risk, maybe it’s ok to also add some currency risk – just be aware of how much risk you’ve added!
    • In my current situation, I’m not worried that about a third of my cash+bonds allocation is in USD. Even the remaining two-thirds is still a healthy cushion, if a major currency swing were to coincide with my emergency.
  • Taxes are still inevitably complicated, although it’s not too bad for most of the kinds of accounts you’ll use for an emergency fund
    • Big picture, the UK and US both tax interest from savings accounts or bonds as income, so you’ll be taxed at whatever your marginal income tax rate is (20, 40, 60, or 45% in the UK; 10, 12, 22, 24, 32, 35, or 37% in the US). The UK has a pretty generous personal savings allowance, at £1,000 (basic rate), £500 (higher rate), phasing out at the additional 45% tax rate. So if you’re under that UK PSA, you may well owe a bit to the US if you don’t have other passive category foreign tax credits to offset it, or if you’re using the Foreign Earned Income Exclusion (since this isn’t earned income, the FEIE doesn’t help).
    • Realistically, you’re not going to make that much interest on an emergency fund today. Even a quite big e-fund – say £6,000 monthly spending and you want 12 months of spending, so £72,000 – is making you something like £720 a year at 1%, maybe £1,080 at 1.5%. Even at the highest tax brackets, that’s not a huge impact on your finances, but I know we’d all prefer to pay as little as legally feasible to HMRC & the IRS.
    • A few ways of cutting back on the tax:
      • If you’re above the PSA, you can avoid UK tax by using Premium Bonds or an ISA (Cash ISA or hold bonds/fixed income/etc. in a S&S ISA). You’ll still be subject to US tax, though.
      • You could also hold bonds/fixed income/money market/etc. in an IRA. Most practically this would be a Roth IRA, so that you can withdraw the contributions any time without penalty, although you can also use the “money is fungible” principle and sell equities in a taxable account to generate cash for spending and then sell the bonds/whatever to buy equities in an IRA – you’ve effectively taken the cash out of the IRA, just with a bit more shuffling around.
      • US Series I and Series EE bonds give you the option of deferring US tax until the bonds mature or you cash them out, or you can pay tax on an annual accrual basis. UK gilts work similarly at first glance, although they’re not one I’ve dug into deeply.
        • I don’t know for sure how the other country respects the deferment vs accrual option for bonds from the first country. For my Series EE bonds, I use the accrual basis for both my US and UK taxes, because trying to do them differently might make my head explode! (bad enough I do the accrual for two different tax calendars…). That’s one I can’t guarantee I’m doing right, but the interest is small enough I’m not going to sweat it – worst case, I’m paying HMRC slightly more and quite a few years earlier than they’d get paid otherwise.

Practical Thoughts on the New Health & Social Care Levy

By now, we’ve all heard of the new Health & Social Care levy – but what does it really mean in practical terms? I’m not going to talk about the politics, or whether the levy is actually fit for purpose to improve the NHS and social care – I’m mostly keeping this blog apolitical.

However, I think it’s worth a quick look at what the levy is and what it means for us – by “us”, I mean people saving and investing for retirement in the UK.

What is the Health & Social Care Levy?

In short, a new/increased tax from April 2022 and an increase in the dividends tax (all the gory details are in the government’s paper). For the first year starting in April 2022, it’ll show up on your payslip as an increase to your National Insurance tax, before splitting out as a separate line from April 2023 (IT changes take time!) For most employees, National Insurance is in three bands for the employee portion (your employer also pays as an employer contribution):

  • Less than about £9,568 a year: 0% – not changing
  • £9,569 to £50,270 a year: 12% – now increasing to 13.25%
  • Above £50,270 a year: 2% – now increasing to 3.25%

The increase also applies to higher income (>£9,568 a year) self-employed (Class 4) National Insurance, but not to Class 2 (lower income self-employed people) or Class 3 (voluntary contributions to fill in gaps). So it pretty much hits everyone working with income above about £9,568 a year. It also expands, from April 2023, to cover people above State Pension age who are still working – today, they don’t pay any National Insurance, but will start paying this 1.25% levy.

Since the new tax is a flat 1.25% on everything above £9,568 a year, if you want to know how much you’ll pay, just take your taxable income (after any salary sacrifice pension contributions, etc.), subtract £9,568, and multiply by 1.25%. Example: £60,000 taxable income – £9,568 = £50,724 * 1.25% = £634 extra a year.

And for dividends, the tax rate is aligned to your overall income tax rate, with a 1.25% increase on each rate:

  • Basic Rate (20%): dividend tax of 7.5%, now increasing to 8.75%
  • Higher Rate (40%): dividend tax of 32.5%, now increasing to 33.75%
  • Additional Rate (45%): dividend tax of 38.1%, now increasing to 39.35%

Dividend tax only applies above the Dividend Allowance (£2,000 a year), and of course doesn’t apply within an ISA, Pension, SIPP, IRA, 401k, etc. So very roughly, at a 2% dividend yield you’d need £100,000 of taxable dividend-paying investments before paying dividend tax, but now at a higher rate. There’s plenty of people on a FIRE (or normal retirement) path with that level of taxable investment, of course.

The other group that’s substantially affected are limited company directors who pay themselves via dividends rather than income – I won’t speak to this group in any detail, because limited companies in the UK are something I haven’t studied at all, beyond knowing that US tax law makes this a complicated area!

What do we get for our money?

Some of the extra money goes to the NHS – no actual change to anybody’s entitlement for NHS care, just try to cut down the backlog. Enough said – the proof will be in the pudding how much difference this really makes.

The bigger systematic change is in social care. Under the current system, everybody (in England at least – slightly different in the other countries) who has assets over £23,250 has to pay for their care in full. In some cases, this means selling family homes, and obviously severely impacts the ability to support children, grandchildren, charity, etc. Not passing judgment on whether that’s right or wrong, there’s a fair debate to be had as to whether end of life care is the responsibility of the individual or the state. The new system shifts the balance – it was already mixed between the individual and the state, but now the state takes more of the responsibility (although far from all!).

Huge caveat: the cap and subsidies only apply to the “social care” part of the cost of care. It doesn’t include the “hotel” or “residential” part of the cost, which can be substantial – often around 1/3 of the weekly cost of care.

To that end, the new system splits into three buckets:

  • If your assets are less than £20,000, you pay nothing towards your care from your assets, although may still pay from your income (pensions, etc.)
  • If your assets are between £20,000 and £100,000, there’s a sliding scale of means-tested support – you contribute no more than 20% of your assets a year, plus a contribution from income.
  • If your assets are over £100,000, you pay the full cost of care up to a cap of £86,000. After that, you pay nothing from your assets towards your care, although you’re still paying for the “hotel” costs.
    • If you start out a bit over £100k but the cost of care pushes you below £100k, you get some of that means-tested support from the bucket above.

I expect the vast majority of my readers plan to have more than £186,000 in assets by the time most people expect to need social care (hopefully well after State Pension age!), so will fall into the third bucket.

Is it a good deal for us?

Again setting aside any moral arguments about the need to take care of the less fortunate in life – is this plan good value for money for those of us who invest carefully over many years in the hope of a comfortable retirement?

One way to think of this plan is as a forced purchase of long term care insurance. Since long term care insurance hasn’t been sold in the UK for a while, it gets tough to compare – I tried looking at the US as an illustration, but the cost of care is too different (much higher on average in the US). So we’ll just try to think it through with UK numbers. The government paper on social care says it typically costs £700 a week – let’s round up to £40,000 for a typical year of care. That’s just the “care” costs, not the “hotel” bit.

On average, somebody who needs care needs about two years of it, and about 70% of people need care. So that makes our expected spend £56,000, with massive variations. There’s a good chunk of people who won’t spend anything at all, but also a long tail – the people who might spend decades in care. We can look at the value in three broad buckets:

  1. Those who never need care: these people now pay an extra 1.25% and get nothing for it (aside from whatever part goes towards improving the NHS rather than social care – impossible to measure right now).
  2. Those who only need a typical amount of care: these people, assuming they have assets over £100k, will cover their entire cost of care from their assets and/or income, because the total cost is less than £86k before they die, plus the hotel costs. They also pay an extra 1.25% and get nothing for it.
  3. Those who need a lot of care: these people spend their £86k in care costs and then the government picks it up from there, plus a contribution from their income and they still need to cover the hotel costs. But it’s a significant reduction from the uncapped cost of care until your overall assets fall below £23,250.

This is a pretty classic case for insurance – when you think about home or car insurance, you put money in every year hoping that you don’t get anything back. On average, you will spend more than you ever get back, but there’s a small group of people who have very high expenses due to some kind of disaster, and they get more out than they put in. Effectively, for people with assets over £100k, the new levy is “catastrophic long term care insurance” – it won’t cover “routine” or “expected” care, but for the tail of people that need a lot of care, it puts a partial cap on your costs.

Of course, you don’t get to choose how whether or not you buy the insurance, and the price is indexed to your income rather than your risk, but that’s what we get. Given the lack of any comparable commercial insurance options, it’s really tough to say whether this is good or bad value for money, for the benefits offered by the “insurance.” There’s a case to be made that nobody besides the government could insure the long tail of protracted care needs – it might not be commercially viable.

What to do about the remainder of the cost? Realistically, unless a new “care gap insurance” springs up, our only choice is to self-insure. In most cases, people who are investing for retirement, especially early retirement, will be able to absorb an £86k cost at the end of life. Really, it becomes an estate planning problem more than a drawdown/cashflow problem.

What’s a bit more challenging to handle are the hotel costs, but hopefully those can be absorbed by your remaining cashflow, since the rest of your expenses are probably minimal once you’re in care. At something like £500 a week or £26,000 a year, you’d need £650k at a 4% withdrawal rate to cover the hotel costs indefinitely. Add in any state pension, social security, etc., and that number falls even more. So except in the leanest of FIREs, or in a case where both partners need extended care (rare but possible) we’re probably ok, even after taking an £86k hit to assets. The new plan reduces the risk of a very long care stay reducing our assets to practically nothing, albeit at a substantial cost during our working lives.

How do we minimize the cost?

There’s no major new strategies here – good tax management that worked on the “old” system works just as well or even better on the new one:

  • Salary sacrifice pension contributions are even more valuable, since they completely avoid the new 1.25% tax.
  • Keeping high-dividend investments in tax-advantaged accounts is now slightly more important. Dividend rates are still lower than income rates (which apply to bond interest) though, so the overall prioritization of tax-efficiency probably doesn’t change.
    • You could argue that currently low bond yields might push some people to put high dividend investments in a tax-advantaged account over a bond (e.g. 3% dividend taxed at 39.35% = 1.82% after-tax return, vs 1.5% bond taxed at 45% = 0.825% return), although the 1.25% dividend tax increase doesn’t change that math much.
  • There may be some nuances in drawdown and estate planning, depending on how the asset calculations work. That level of detail isn’t clear yet, but maybe you want to prioritize gifts earlier in retirement, or maybe annuities start to look more attractive if they’re not an “asset” but a pension in drawdown is? Just really don’t know yet.

It will be interesting to see what happens to wages – do employers increase them to offset the higher tax? Or do they pass on the higher NI tax that they’re paying, reducing wages (or at least reducing raises to below inflation). And if they do increase wages, whether because of the new tax or due to the tight labor market, what does that do to inflation? We’ll have to see.

What do you think? Does the new system change your approach to planning for late retirement, or your estate planning?

My Approach to Bonds (and Cash)

I wrote about my overall asset allocation a while back (Part 1 & Part 2), but have been doing a fair amount of thinking late regarding the bond part, particularly in light of some more substantial cash savings from our remortgage that are eventually planned for home improvements/extensions, but with no clear timeline (at least years, realistically). Keeping my 10% in bonds plus more than another 15% of my overall investment portfolio in cash felt too conservative, but then do I just ignore the cash because it’s sort of short term savings? But those home improvement plans are ill-defined at best, and I hate to see that much money sitting on the sidelines for potentially years, at least without a coherent plan.

After a lot of back and forth, tinkering with asset allocations, playing with how to account for cash, reading about bond tents, etc., I came to two simple conclusions:

  1. Treat bonds and cash as a single asset category
  2. Increase my bonds/cash allocation to “my age minus 15” – making it 21% now

Bonds and Cash – one category?

We’re probably all aware of the challenges facing bonds right now:

  • Yields are miserably low – 1.31% on BND, 1.41% on BNDW, 1.04% on a 30 year gilt (0.13% on a 2 year! why bother?)
  • Interest rates have almost nowhere to go but up. I’m not predicting that rates will rise soon, since they’ve really been consistently low since the 2008 crash (small ramp up leading up to the pandemic, but still historically low). Maybe they move sideways for another decade or two, but, barring going substantially negative, they can’t go down much.
    • If interest rates stay flat, bond prices don’t change – all we get is the (very low) yield
    • If interest rates rise, the prices of bonds we own today go down
  • That results in what feels like a substantial downside (risk of prices falling) without a lot of upside.
UK (Bank of England) interest rates – US and other developed country ones look similar, sometimes worse!

But it’s worth reminding ourselves of the reason for having bonds at all, instead of just 100% equities:

  • Bonds are less volatile – even when their price changes, it does so slowly. Look at the chart below, specifically 2000, 2008, and 2020 where stock prices change rapidly and bond prices move slowly.
  • There might be an inverse relationship to stock prices, through the “flight to safety”. When stocks go down, some investors get scared and move into bonds. But again, look at the chart below – the bond price increases during stock crashes are far less than the stock decreases. If you wanted to make money during the crashes, you’d need to be massively tilted towards bonds, which would leave you a lot poorer in the good times. If your crystal ball is good enough to predict the crashes, you’d make a lot more money by shorting stocks than holding bonds.
  • For those of us with investments in multiple currencies, having bonds in our “home” currency can be a tool to manage exchange rate risk.
  • We know that equities tend to have higher growth rates than bonds, over the long term, so we are deliberately choosing less growth as a tradeoff for less volatility.
  • Some day, bonds may be useful to me as a stream of income, but right now I’d just as soon the money stay invested – I’m a good ways off before I start living off my investments.
  • Bottom line: bonds reduce volatility, at the cost of lower long-run returns. I want my bonds to preserve value more than I need them to grow – that’s the job of equities.
From the excellent Portfolio Visualizer tool

Putting those two things together, and bonds start to sound a lot like cash to me, in today’s environment: low yield (a bit higher than 1% is “good”) and want them to preserve value, at least in nominal terms. So why treat them as entirely separate asset categories? Now, this wouldn’t apply if you’re interested in particularly risky bonds – emerging markets, “junk” corporate bonds, etc. Those I would consider something different and closer to equities, and they’re not something I choose to include in my portfolio. But if your bonds are developed government or high-quality corporates, they feel pretty similar.

So, at least for me, it makes sense to mentally combine my bond and cash holdings into a single asset allocation.

What bonds & cash do I hold?

Most of the bonds I hold are pretty cash-like in the first place – the chances of losing value in nominal terms are remote:

  • Premium “Bonds” (59%): I put bonds in quotes, because I consider Premium Bonds cash rather than bonds. They’re guaranteed by the UK government and have no risk of loss, plus pay out at a 1% prize rate.
    • There’s some element of luck involved here, although I have tended to average around the prize rate – this is a large enough holding that the luck starts to average out. Aside from being one of the best interest rates available for cash today (you can get marginally better if you’re willing to lock up your money for a few years), they’re a bit of fun too!
  • TSP G Fund (22%): a unique holding for the US government employee Thrift Savings Plan, this pays a US government bond long-term interest rate (1.375% as of September 2021) but without risk of loss. The interest rate varies with overall US bond rates.
    • If I was able to move more money into the G fund, I’d increase this percentage and drop the Premium Bonds allocation, but since it’s basically a 401k for a former employer, there’s no way to do that.
    • I could reduce my exposure to other TSP funds (basically US and Developed ex-US equities) in favor of the G fund, but then I’d need to move money from Premium Bonds into those equities, which is a challenge due to all the normal hoops for a US citizen in the UK (PFICs, PRIIPs, etc.). The G fund is good, but not so good that I want to start a US & UK taxable individual US stock portfolio like I’ve done with UK stocks in our ISAs! Doing the US bookkeeping and taxes for 42 stocks in our ISAs is plenty; doing both US and UK bookkeeping and taxes for more stocks makes my head hurt. Plus I’m a believer in indexing, and am pretty confident that the diversification due to indexing is worth the 0.375% difference between G fund and Premium Bonds.
  • US Series EE bonds (10% of my cash/bonds allocation): these are gifts from my parents when I was younger, slowly maturing. Because they’re relatively old, the interest rates are relatively good, plus the guarantee for EE bonds to double after 20 years means a minimum interest rate of roughly 3%. I’m not buying new ones, but won’t be selling these until they reach maturity over the next 25 years.
    • I’m not buying new ones because I’m paying income tax on the accrual basis for these (a decision made for me long ago). That’s nice, in that I don’t owe chunks of tax when the bonds mature, but also means that any more EE bonds (or I bonds) would add to my tax burden while I’m in a relatively high US and UK tax bracket today.
  • UK gilt fund in my UK pension (<1%): I’ve just started building this position from £0, and it won’t amount to much for a long time (just a couple hundred pounds a month). But of all these options, it’s the only one exposed to the risk of rising interest rates, the only “traditional” bond fund. But it’s in a tax-deferred account, practically no risk of default, and starts to slowly build an exchange-rate buffer, since effectively all my expenses are in GBP but a lot of investments are in USD.
  • Other cash accounts (9%): I include our various checking/current and savings account in my bonds+cash number. This is small stuff at paltry interest rates (0.5% is “high yield” these days), just ready spending and very short term savings, a few thousand £ & $. I could just as easily exclude it, but my spreadsheet already has it calculated. Not planning on this growing over time, it might slowly shrink as I continue to whittle away at closing old accounts.

Other bond options and why I’m not using them

The options above are not terribly traditional, and I know not everybody has access to the G fund. A few thoughts on some of the other options:

  • Standard bond index fund (BND, BNDW, BNDX, or UCITS ETF equivalents): very low yields, more downside than upside in price. Simple comparison: you can get 1% in risk-free Premium Bonds or 1.3%ish in a bond fund with risk of the price going down if interest rates go up. Is that extra 0.3% really worth it? On £100k invested, that’s about a £3k difference over 10 years – not nothing, but not going to make a huge difference compared to the risk of loss.
    • You can tilt these however you like, in terms of risk, duration, etc., but it doesn’t change the basic problem. And if you get very risky to chase yield, this starts to feel more like the risk/benefit tradeoff of an equity, not a bond.
    • For me personally, this really doesn’t make sense compared to the G fund, at the same interest rate but no risk of loss.
  • Individual bonds (UK gilts or US treasuries): a bond ladder is an interesting idea, allowing tailoring of duration to meet your goals – once upon a time I had a CD ladder, back when CD interest rates weren’t rock bottom. A few challenges though:
    • Same or even lower yields as the bond funds, even at really long durations (which add to the risk of comparative loss if interest rates rise)
    • Tax efficiency: the US and UK tax bond interest at income tax rates, which means a lot of that low yield goes right back to a government. I could put them in my wife’s name to get around that, or in a tax-advantaged account. But that would mean my ISA for gilts, which has fairly horrific transaction fees compared to the return on bonds, or my Roth IRA for treasuries. In both cases, I don’t want to use tax-free (rather than tax-deferred) space for bonds, either.
    • Fair amount of effort for the yields. Between bookkeeping for US & UK taxes and the ongoing management, this is just more hassle than its worth to me.
  • Series I bonds: these are a pretty attractive option, and definitely worth considering. 3.54% interest (as of Sep 21), balanced with some lockup periods and restrictions on how much you can buy.
    • If it weren’t for the accrual basis that I’m already locked into using for tax on the interest, I would look at these more seriously. For those of you without that restriction, this could be a nice core holding, and you could defer tax on the interest well into the future, when you might be at a lower tax rate. For me, that would knock my after-tax return down to about the same level as the G fund (pre-tax, but easier to manage those taxes later on).
    • You do have to deal with the archaic TreasuryDirect website. It’s usable, but it’s straight out of the 90s.
    • More Series EE bonds would fall in a similar bucket. Some pros and cons compared to the Series I, I think I would tend towards Series I first, but also worth looking at.
  • Very high yield savings accounts: you can get 3%ish from a savings account, that sounds great right?! Wait, but you can only contribute £50 a month and only get that rate on up to £1,000? Sure, there’s a bit of money to be made here, but if you’re managing even a moderately sized portfolio this just doesn’t help much. No harm in doing it, but it winds up being a lot of effort if you want to get any significant amount of money into these kinds of accounts.
    • Bank account switching bonuses kind of fall in the same bucket. I’m not opposed to switching to make a quick £100, but that’s more of a side hustle than an asset allocation strategy.

Why 21% in bonds/cash?

First off, there’s no right answer to this question! Bogleheads have a great primer on asset allocation, if you haven’t read it already. But the gist is that there are plenty of rules of thumb, but that’s all they are. At the end of the day, you have to pick something you’re comfortable with, and “my age minus 15 in bonds” feels good to me. 21% is enough to provide some volatility dampening without having a huge impact on the return. It’s not nearly as conservative as “my age in bonds”, nor as aggressive as “100% in equities until retirement”. It’s somewhere in the middle, and it feels right to me.

It also puts me on a path to a bond tent, helping to address sequence of returns risk in early retirement. Some people would argue it’s early to start building that bond tent, but since 21% feels about right now, building another 1% a year over the next 15 years or so feels pretty reasonable. That would have me going into early retirement with a bond allocation around 36% – might play with that and bump it up a bit in the years closer to retirement, see how the world looks by then!

There’s a lot of “feels” in the description above – this is definitely one of the fuzzier bits of FIRE or investing generally. On one hand, you’ve got people saying that 50/50 is the logical default allocation, or that “your age in bonds” is plenty aggressive. On the other, you have people holding 100% equities all the way through accumulation and retirement. Without a crystal ball, there’s no way of knowing the optimal asset allocation, so all you can do is pick something that helps you sleep at night. I’ve been very fortunate to do well so far in my accumulation, and having a bit of bond/cash ballast in my portfolio helps me sleep.

My target asset allocation, as of September 2021

Other considerations – Inflation, Mortgage, & Emergency Fund

Some of you might be screaming by now “but what about inflation!?! You’re losing money in 21% of your portfolio!” And you’re right – inflation numbers are a bit murky with the effects of the pandemic, but it’s pretty clear inflation is higher than the 1 to 1.4% or so I’m getting from anything in my bond/cash allocation. And that’s ok – it’d be nice if interest rates beat inflation, but it’s hardly uncommon for them not to. The 79% of my portfolio in equities needs to beat inflation and deliver real returns – the bonds and cash don’t. Their job is to dampen volatility.

The obvious logical inconsistency is that I’m holding bonds/cash at 1 to 1.4% and paying a substantial mortgage at 1.26%. If you look at it a certain way, we took money out in our remortgage at 1.26% just to put almost all of it in Premium Bonds at 1%ish – that doesn’t make any sense! That was a deliberate decision though – we are paying a small premium (roughly £200 a year due to the delta in interest rates) in order to have the option of using that money for a future house extension. For us, that option is worth the price, and probably cheaper than it would have been to do a shorter remortgage, not take the money out, and then do another remortgage to access that money – not to mention the hassle or the risk that mortgage rates may rise in the next few years from their current extreme lows. So there’s a method to the madness, even if there’s also a very rational argument for not holding any bonds or cash that pay less than what our mortgage costs.

The last question might be “where does your emergency fund fit into this?” The answer is that we don’t have an emergency fund, at least not in the traditional sense. I’ll expand my thoughts on emergency funds in an upcoming post, but with 21% of our portfolio in cash/bonds, that’s about 2.5 years of spending in investments that are extremely safe, so I don’t see a reason to slap the “emergency fund” name on a separate pot of cash.

So What?

That’s a lot of words to describe how I’ve wrestled with today’s bond conundrum – and sadly, I don’t think there are many universal lessons, because this is a very personal decision. I just hope that my thought process might help prompt some thoughts of your own – I’d be very interested in hearing your views on asset allocation and how you are (or aren’t) using bonds in your portfolio, including any violent disagreements 🙂

S&S ISA Experiment – September 2021

I haven’t provided an update on my S&S ISA experiment since the May 2021 update, but 3 months on I think there might be a few interesting things to note.

Very quick reminder – because of the challenges in holding index funds outside of a “pension” for Americans abroad, I’m trying a “pseudo-indexing” approach in my ISA, buying individual stocks in the hope of replicating the performance of the FTSE 100. I’m baselining my performance against a FTSE 100 ETF (CUKX, not VWRP as I mentioned before – that’s an all-world fund, so not quite a fair comparison!).

Major updates since May:

  • I was due to remortgage our house, and with interest rates so absurdly low (1.26% for our new 5 year fix), we decided to take some cash out. Some of that is earmarked for future home improvements, but I used part of it to max out both my and my wife’s ISA allowances for the year.
  • For my wife’s ISA, I picked a different 20 stocks – still all UK ones, but because I’d already picked 20 of the largest UK companies for my ISA, this means hers has quite a few smaller companies. A few of these are bordering on stock picking instead of indexing – still companies I plan to hold for the long term, but an £800 million market cap company is quite different compared to a £131 Billion one. Average market cap is £39 billion in my ISA, and £9 billion in hers. Will be interesting to see how much of a difference that makes!
  • I also opened LISAs for both of us, shortly before my wife turned 40. I don’t plan on contributing a lot to these, because my biggest concern is the gap between early retirement and pension/401k/IRA access ages, but figured it was prudent to open one before she aged out. Each of them only has about £125 in them (£100 from us, £25 from Her Majesty), with a single stock (different from the other 40 in our S&S ISAs), so not going to move the needle.

Performance Update

Big picture, there’s not much difference to be seen between our ISAs and the FTSE 100, although, to be fair, most of the change in value is driven by ongoing contributions. It will be interesting to see any difference between now and the next contributions in April 2022.

Break it down some more, and there is a rather more obvious difference in the monthly growth figures, although they wind up averaging out to pretty much the same:

And when you break it into the individual stocks, the differences between them are particularly striking. As a prime example, we bought M&S in my wife’s ISA only a few days before the price spiked – pure good luck, rather than any foresight on my part!

After expenses, both for purchase and predicted expenses for sale, we’re up a total of not quite £300 on a £40,500 investment. Hardly life-changing, but, by pure luck, it’s about £700 better than we’d be doing in a FTSE 100 tracker fund. Since this is replacing a chunk of UK exposure in my overall asset allocation, I’m happy with that.

Observations

Hargreaves Lansdown, my ISA brokerage, puts out a lot of articles. Most of these are shilling for active funds that I can’t buy and wouldn’t even if I could, but occasionally there’s something interesting. In particular, one on the evolution of the FTSE 100 index caught my eye, especially this graphic:

It’s obvious that Materials (mostly mining) and Financials (mostly banks) are a huge part of the FTSE 100 – 36.6% to be exact. But I’ve chosen to skip the largest players in these sectors, so my “pseudo-index” is missing around a third of the actual index. I do have some exposure to those sectors: CRH is a construction materials company, Croda in chemicals, and we have a few companies around the financials space (Aviva for insurance, Experian in mostly credit rating, the London Stock Exchange itself, and a merchant bank in Close Brothers). But we’re missing the obvious big names: no HSBC, Rio Tinto, BHP, Glencore, Anglo American, Barclays, Lloyds, and so on.

In a way, it’s remarkable how closely my ISA is performing compared to the index despite this discrepancy, at least so far. I haven’t changed my opinion on these sectors – the extractive materials companies in the FTSE are borderline (or beyond!) exploitative while the banks aren’t much better, plus I expect them to struggle in this extremely low interest rate environment. You can get a higher interest rate from Premium Bonds than on some mortgages!

So, I’m not changing the allocation of my ISA – the high transaction fees (about £24 to sell one and buy another) put me off anyway. But if something dramatic happens to either the Materials or Financials sectors, it wouldn’t be surprising if my performance diverges from the index.

Overall, I’d say the experiment is going well – I’m generally tracking the index, no major concerns there, and the mechanics are manageable. I do have ongoing Excel sheets for both dividends and basis tracking, so I’m not expecting US taxes to be anything too terrible, but we’ll see. So far, so good!