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Bonds are worth thinking about

Frank Bacon wants to supplement his retirement income with dividends, but he shouldn't discount bonds, say our experts.
November 19, 2012 and Colin Low

Frank Bacon is 58 and has been investing on and off for 25 years, although up until two years ago he had not owned any shares for eight years. He initially 'played' with penny shares (which typically cost below £1 but are regarded as high risk as their value can fluctuate dramatically over short spaces of time) occasionally buying other investments, and two years ago started investing with a more disciplined and focused objective.

Reader Portfolio
Frank Bacon 58
Description

Shares and funds

Objectives

Additional income during retirement

Mr Bacon's investment objective is additional income during retirement, but without sacrificing capital if possible.

His current retirement funds are:

■ A small final-salary pension (about £2,000) available from age 65.

■ Three money-purchase pensions, worth about £150,000.

■ His wife's final-salary pension (about £6,000) available when she turns 60.

"I have always contributed as much as I could afford to a money-purchase pension and had assumed I would be secure in retirement," he says. "However the pensions have performed very poorly and annuity rates are appalling. Although I still pay into my company pension to get the free money, I now put all spare savings into me and my wife's self-select individual savings accounts (Isas). As we both work and have no mortgage we have no real need for a reserve fund as we can fairly quickly build up a lump sum if required."

Mr Bacon says he is cautious, but thinks income-generating equities are more likely to provide a decent return. He is transferring his money-purchase pension funds into a self-invested personal pension (Sipp) with a view to taking income drawdown instead of an annuity.

"My decision to pile into equities so close to retirement instead of the usual strategy of moving into safer investments such as gilts or bonds differentiates me from the average investor," says Mr Bacon. "However we live in highly unusual times and nobody has any real idea what is going to happen. Moving into bonds could prevent large losses in the case of a crash, but it also prevents large gains in a market surge. I am engaged in a bit of a gamble - assuming that equities are relatively cheap at the moment and more likely to rise in the medium term.

"However, I do not intend to become a trader. I intend, like Warren Buffett, to keep my holdings and just take the income, not getting too worried about short-term drops in share values. Dividends are not guaranteed, may fall or be suspended, but hopefully I am building up a sufficiently diversified portfolio that most shares will be paying at any one time.

"I intend to concentrate on buying shares in long-established income investment trusts, which have squirrelled away reserve funds to enable them to continue paying dividends during hard times.

"When I start taking my pension I intend to take the 25 per cent lump sum as a reserve fund."

 

Chris Dillow, Investors Chronicle's economist, says:

You are, of course, entirely correct to say that nobody has any idea what's going to happen in the future. But there's one thing sillier than making forecasts - and that's staking money on them. As you say, you're taking a gamble here. So let's, roughly, quantify the size of your bet.

Now, your actual portfolio seems to me entirely reasonable, a nice mix of defensives and overseas investment trusts. Note, though, that the latter are all correlated with the general global market and hence each other.

Let's say that the expected real return on this portfolio is 5 per cent a year with a standard deviation of 20 percentage points; your defensive shares reduce these numbers, but your emerging market funds raise them. This gives you a roughly one-in-four chance of losing money (after inflation) over the next five years. Are these odds too high?

You say that you're "not too worried" about short-term losses. I'd question this. For one thing, long-term losses are also possible. Also, what matters is not dividends but total returns. If your shares rise a lot, you can, in effect, create your own dividends by selling some and still be richer than you are now, but if they fall you cannot do this. So losses must matter. And there's projection bias, too. Plenty of people have claimed to be untroubled by the possibility of losses, only to change their mind when they actually lose money. This is an especially bad error if it leads them to sell at the bottom.

Ordinarily, financial advisers and economists recommend holding cash or bonds as a way of diversifying equity risk. But you and your wife have another way of diversifying - by working. You say your jobs enable you to build a lump sum quickly if needed. This ability, in effect, gives you a way of spreading equity risk. Human capital - earning power - can diversify equity risk just like bonds and cash do. This is a good reason why young people - who have years of labour income in front of them - are usually advised to hold lots of shares. And in this sense you are young for economic purposes.

This raises two questions. First, if you do lose money on shares, will you really keep your jobs? For some people, the sort of economic downturn that hits share prices also throws them out of work. For these, work is poor protection from equity losses. Are you in this category? Beware of wishful thinking here.

Secondly, do you enjoy work? If so, then postponing retirement in order to offset equity losses isn't too painful. But if you hate your job, it is. Debt bondage is a terrible thing, but so's equity bondage.

Even if the answer to both these questions is 'yes', a problem remains - you might not have many years of work ahead of you, so your means of spreading equity risk is a diminishing asset.

Luckily, there might be a painless solution to this problem. I suspect that annuity rates will rise over the next few years and that share prices will, too. There should come a time, therefore, when you can usefully annuitise some of your portfolio.

This, though, is only a probability, not a certainty. And it's in this context that bonds are worth thinking about. Their virtue is not just as a means of diversifying equity risk, but as a hedge against annuity rate risk. If annuity rates stay low or fall further, you'll make profits on bonds which, in effect, hedge the loss of future retirement income.

There is, of course, a drawback here. Expected real returns on default-free bonds (gilts) are nugatory, so it's expensive to use them to hedge annuity risk. Not doing so is, though, as you say, a bit of a gamble.

 

Colin Low, chartered financial planner and managing director of Kingsfleet Wealth, says:

It appears that over the past few years you have suffered from the typically British mentality of investing too conservatively, but you have now seen the light and are moving into real assets. I am pleased to see that consideration has been given to investing for the long term and potentially benefiting from the outperformance of higher levels of equity holdings. Most of us invest in companies and not countries, and companies are run for profit from which dividends are paid.

With average life expectancy being much higher than previous generations, you are right to think of your investments on a much longer-term perspective. You don't give any indication of an intended retirement age, so perhaps you want to keep this as flexible as possible, in which case income drawdown (or possibly even phased drawdown) could be of significant benefit to you.

I also feel there is merit in considering a consolidation of the three money-purchase arrangements, but care should be taken in three areas.

Firstly, ensure there are no valuable guarantees built within the existing plans, such as high guaranteed annuity rates. Secondly, confirm there are no penalties on exiting these arrangements and, thirdly, have a thorough understanding of all the costs that will apply to the Sipp. In the new world of lower fund management fees after January, make sure you reap the full benefit. Many funds are reducing their annual charges so if you choose not to involve an adviser, the total expense ratio should be lower. Check for all the costs of running your portfolio within a Sipp - transaction fees often catch people out.

I would seriously consider building up a cash buffer of three to six months' expenditure. It seems very dull, but it is wise to avoid having to borrow or crystallise investment assets in the event of an emergency - and, at the moment, this is what you would need to do. Look for a simple savings account that can be linked to your current account for ease of access: you're not going to earn much on the account so simplicity and ease of access are better.

As far as the investment portfolio is concerned, you have made some interesting selections over the past few years, but your most recent trades highlight the danger of your strategy. Sainsbury has been an excellent performer over the past year, whereas RSA has been more disappointing. Middlefield (MCT) is quite an unusual selection and certainly carries additional geographic and liquidity risks - the share price has performed strongly over the past year, even if the net asset value (NAV) performance has been disappointing (read our tip on this investment trust).

Overall, I think you have the right idea in looking to invest in more diversified assets such as investment trusts. I would advise you to steer clear of sector or geographic-specific trusts, as I do not feel your portfolio could withstand the effects of a significant loss.

More collective funds rather than individual equities would also be a way of taking stock-specific and event risk out of your portfolio, and your exposure to Far East investment trusts gives me cause for some concern. I suggest Lowland Investment Company (LWI) and Scottish Mortgage Investment Trust (SMT) for a more diverse investment trust solution. As usual, beware the additional gearing and discount/premium issues that investment trust investing involves.

In the open-ended space, we recommend Artemis Global Income (Isin: GB00B5VLFH80), AXA Framlington UK Select Opportunities (Isin: GB0003501581) and M&G Recovery (Isin: GB00B7759Y38) for a diverse UK portfolio holding. These funds are multi-cap and have a highly pragmatic investment strategy rather than being slaves to value or growth processes.

Also consider non-equity assets. I realise your concern about holding bonds but even our most adventurous clients have an exposure to some additional form of diversified assets, including fixed-income funds. For example, M&G Optimal Income (Isin: GB00B76FNM05) has a very broad mandate.

I would also suggest you take particular care over the tax wrappers in which your assets are held. I do not have your income details, but yielding assets held outside of an Isa could incur an additional tax liability. It's often best to put yielding assets in an Isa and use your capital gains allowance for growth assets. Obviously, being married is helpful here as you can double up your allowances between you.

But the key is to continue what you are doing. Set out a plan or work with someone to devise a plan, and keep checking on it to make sure you are on track to achieve your goals.

 

Frank Bacon's share and trust holdings

Share or trustEPICNumber of shares heldPrice (p)Value (£)
United Utilities UU.1449652.259451.1
Balfour BeattyBBY1384241.53342.36
Aberdeen Asian Income Fund AAIF45502059327.5
Aberdeen Latin American IncomeALAI10160101.410302.2
AvivaAV.18003305940
RSA InsuranceRSA4509112.15054.59
Morrisons (WM)MRW2583260.16718.38
Sainsbury (J)SBRY1957339.36640.1
National Grid NG.882693.56116.67
UnileverULVR822,3411919.62
Utilico Emerging Markets UEM32601615248.6
Standard Life SL.1400306.94296.6
JPMorgan Global Emerging Markets Income JEMI7600114.58702
JPMorgan European (Growth)JETG32561605209.6
Murray International Trust MYI2839892798.87
Murray Income Trust MUT3606602376
Middlefield Canadian Income TrustMCT66001056930
Temple Bar Investment Trust TMPL2659702570.5
Henderson International IncomeHINT33331033433
Henderson Far East Income HFEL2600294.117646.86
Schroder Oriental Income FundSOI2000177.53550
Merchants TrustMRCH1250367.24590

Total

122164.55

 

Latest trading buys:

■ Sainsbury (UK: SBRY)

■ RSA (UK: RSA)

■ Middlefield Canadian Income (UK: MCT)

 

WatchList:

■ Long established income investment trusts

■ Costain

■ Scottish Southern

■ Carillion