Monday, 31 August 2009

Book Review: Worry-Free Investing (UK edition) by Zvi Bodie and Ian Sykes

"... invest in inflation-linked government savings products"

That quote taken from the first page of the preface conveys the essential message of this book. The basic stance of the book is that essential "cannot afford to lose them" funds should be invested in inflation-linked products and if current savings are not sufficient to reach future goals that way, then one should either save at a higher rate, reduce goals or work longer, but not try to get a higher rate of return by investing in risky stocks.

I must admit to being surprised by the book. Despite the impeccable credentials of the authors (Bodie is a finance prof who co-authored the widely-used Investments textbook and Sykes is a consulting actuary in the UK) and the cover endorsements by a couple of Nobel prize winners, the good content is under-mined by poorly chosen assumptions for a number of examples.

Unrealistic Assumptions:
  • 2% real rate of return in Index-Linked Savings Certificates; the current rate is only 1% per National Savings and Investments; using Bodie and Sykes' own calculator from the downloadable spreadsheet on the book website, that would bump up the required savings rate by almost 5% of salary per year, a huge jump
  • 20 years in retirement; given rising life expectancy, one or the other of a couple is highly likely to survive beyond 20 years, especially if retiring before 65. Life expectancy is just an average - many people die older. If that happens what would one do if the planning has been to run out of money at 85 but one is still alive? Increasing the estimate of years in retirement to 25 by itself raises the requires savings rate by around 3%. Combined, the two factors would raise total annual savings to 24% of salary. To be really sure of being dead by the time money runs out, one might use 30 or 35 years in retirement. Is that realistic? The book's answer to life expectancy and the risk of outliving income from inflation-linked instruments is to buy an annuity. But buying an inflation-indexed annuity with the calculator's total estimate of future savings would, per the FSA website where current quotes can be obtained (it is commendable that the book provides the link), produce an annual income that would be far short - only about 61% - of the desired 70% income replacement.
  • 70% income replaced in retirement - on the other hand, the authors use without comment this oft-disputed piece of "retirement experts" advice; 70% is un-necessarily high in many cases, and significantly controllable by retirees. A lower retirement income can substantially reduce required savings rate - by about 4% using their base case numbers.
  • 10% annual rate of withdrawal from the initial amount of a retirement portfolio. The rule of thumb safe withdrawal rate in retirement is 4% for a mixed portfolio of stocks and bonds, so using an unrealistically high rate destroys the credibility of the book's contention, which is true, that the variability and the sequence of returns during the initial years of retirement make a critical difference in the long term survival of the portfolio. If a person were to withdraw 10% a year from a portfolio consisting only of inflation-indexed securities earning 1% a year, it wouldn't last long either.
  • introducing the idea that stocks are risky, even in the long run, in chapter 1 by showing the decline of stocks in a three year period - that's hardly the long run.
I also found it strange to see the authors showing how to construct a type of principle-protected note by combining bonds with call options. For a book seemingly targeted at the beginner level (later on they say if it is too complicated to pick up the phone to buy index-linked products, then you probably need a professional financial planner's assistance), the idea of buying options is likely far beyond what most people would feel capable of doing. Similarly the future value math formulas peppered through the chapters (and the companion website does not have the future value calculator as promised in the text) will surely seem daunting and complex to the beginner.

There is still a lot to like about this book and much useful advice:
  • defines risk tolerance in practical terms like the safer your projected future earnings, and the greater your ability and willingness to postpone retirement if risky investments perform badly, the higher your risk tolerance instead of emotions
  • stocks did not provide any inflation protection during the high inflation years of the 1970s
  • shows how to calculate value of future requirements and provides an online calculator at the book website
  • shows various methods (specific to the UK) for obtaining extra retirement income from one's home
  • recommending to people who do invest in stocks to do so via low cost index funds and suggests some circumstances when they feel it is appropriate for people to invest in stocks
  • presents a simple, sensible six step process to build a financial plan
  • tells how to find trustworthy professional advice and briefly debunks a number of myths that can lead astray
  • excellent collection of tools and useful links to websites e.g. FSA website for getting a current representative quote for an annuity from various providers, Government Actuary life expectancy tables
This book reminded me that Canada lacks one valuable savings product available in the UK - inflation-linked savings certificates which are completely free of tax. There is certainly a need for something that provides inflation protection and no default risk for a taxable account. As it is now with real return bonds in Canada, the government taxes everything on RRBs, including the inflation adjustment component of the return, which makes it quite unattractive to hold outside a registered account.

I cannot subscribe to the book's fundamental philosophy of taking no risk to achieve financial goals. I believe that investing in a diversified portfolio which includes equities can be a reasonable long term strategy to achieve long term returns that are substantially higher than the ultra-safe inflation-indexed products touted as the answer in this book. Between the ultra-safe strategy and the much riskier 100% stocks approach there is a middle ground. Sure if you don't need to, don't take the risk, but if you do, as most people do, then the restrictive alternatives proposed by Bodie and Sykes should not be the only path. You just need to be aware of the risk you are taking and be ready to do the back up plan of working longer. With the no-risk strategy, you are also sure that you will not have an upside either.

My rating: 3.5 out 5 stars.

1 comment:

Unknown said...

heyy.. I found an excellent annuity calculator here... I think that is the better option before that to buy annuity.

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