Doubts over cautious retirement portfolio

Source: Investors Chronicle, *London Stock Exchange, **Selftrade (as at 7 December 2012)

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Chris Dillow, Investors Chronicle economist, says:

This portfolio seems free from three common errors that investors make. First, many investors are overconfident, and so trade shares too much and incur heavy costs. It's good to see someone who's avoiding this error.

Second, many investors have a confused approach to time horizons - for example, claiming to be a long-term investor but then selling at times of trouble. You have a much clearer approach, recognising that you don't have time to time-diversify, but do have time to postpone buying an annuity - hopefully until a time when rates are better.

Third, many investors make mistakes about mental accounting, thinking of their wealth as comprising separate pots rather than a coherent whole portfolio. Again, you're more sensible - as shown by the fact that you're thinking of part-time work - human capital is an asset, too - and Isas as parts of your retirement fund.

There are, however, a couple of issues here.

One concerns your bond holdings. Remember that bonds are free from price risk (though not credit risk) only if they are held to maturity. But bond funds do not give you this assurance. They do expose you to price risk. Many readers - including me - might think that, with bonds now very highly priced, these risks are heavily to the downside over the next few years, which is the relevant time horizon for you. So why hold such funds?

First, they offer some hedge against your equity investments; it's quite likely that if global markets fall, losses on the equity ETFs in your Isa will be offset by price rises for bonds.

Second, investors approaching retirement face annuity risk - the danger that annuity rates might fall even lower. Bond funds hedge against this danger; what we lose from lower annuity rates we gain from higher bond prices. Personally, I think this is a small danger. But we must always be alert to small risks of nasty events.

These, though, are stronger arguments for holding gilt funds than they are for your high-yield bond funds. The latter expose you to some corporate credit risk, and so are more like equities than government bonds. City Merchants and Investec Monthly High Income both did badly in 2008, for example.

My second issue is that, even allowing for those risky-ish high-yield funds and your emerging markets ETFs, this is a relatively cautious portfolio. And low risk implies low return; yes, defensive stocks such as your infrastructure funds are an exception to this rule, but I doubt they are sufficiently so to overturn this point. This poses the question: will this portfolio deliver sufficient returns over the next five years to finance your retirement lifestyle? If your current wealth is close to (or above) a level sufficient to give you an adequate income, then a risk-averse portfolio is great. If not, remember that it's possible to be recklessly conservative.

Ask yourself these questions: what income do I need in retirement? What income would my current wealth give me at current annuity rates? If the latter answer is much below the former, ask how you plan to close the gap. There are many possibilities: save more; be prepared to work longer; try to cut out extravagant fripperies (an intelligently frugal lifestyle is a much underrated asset). If none of these appeal to you, you're left with two others. One is to hope for a rise in annuity rates - but hopes, however reasonable, should not be a sole basis for investment. The other is to tilt a little towards assets with higher returns.

Colin Low, IMC, FPFS, Chartered Financial Planner and managing director of Kingsfleet Wealth, says:

You have an issue that we find commonplace in many of our clients. Ever increasing life expectancy has brought many benefits to us as a nation. However, for those who have been sufficiently prudent to fund for their retirement, the lifestyle and medical benefits of this continuing improvement have been tempered by the requirement to eke out the value of their assets and savings over a longer period. This raises questions of what risk should be taken with investment and pension arrangements.

Thankfully, some of this risk has been taken by your defined-benefit (DB) pension arrangement, so at least you know that once the scheme is in payment, you are top of the pecking order to receive your pension income. However, any advice in respect of DB schemes must also warn that there are no guarantees on the delivery of those benefits (unless of course, they are funded through public sector bodies).

With average life expectancy generally in the mid-80s now, it could be that upon retirement at 60, you easily have another 20-plus years of income to fund for. It is pleasing to see that you are thinking of using both Isas and Sipps as a means of supplementing income post-retirement as, with some careful planning, this assists in making the total net income as tax-efficient as possible.

I would suggest this whole area is one that requires some very careful cash-flow planning as well as reordering assets to meet with the risk profile that you have expressed. I understand your concern regarding capital loss, but a 20-year term could be seen as the more realistic objective, rather than just the two to seven years of crystallising assets to supplement income. You need to formulate some objectives relating to how much is required to supplement income between receiving your final salary arrangement and receiving state pension. This can then form a part of your 'cautious strategy' using mainly cash, bonds/bond funds and cautious managed funds.

A further analysis will then indicate what is required to supplement your income after you receive the state pension and an alternative portfolio may be required for this purpose.

You are, quite rightly, cost conscious, and investing in ETFs will certainly assist in bringing down the costs of the investments, but the spread of investments in the Isa does seem a little random. It's worth adding that the annual Isa allowance should not be a limiting factor in terms of your saving ability. ETFs (and indeed investment funds) with little or no yield can also be held outside of an Isa, but just be aware of the liability to capital gains tax (CGT). However, very few people utilise their £10,600 annual CGT allowance, so this may be a highly-efficient way of supplementing income at retirement.

Dignity has certainly performed well in the last year, whereas Vodafone's fortunes appear to have been somewhat mixed. If you like the sense of 'having a flutter' then you may well enjoy the purchase of individual equities; however, many of our clients find that they prefer to have a structured and disciplined investment approach that is formulated around future cash-flow needs and attitude to investment risk. But you certainly have a diverse portfolio and you are not reliant on one or two key stocks or funds to provide significant income or returns for you.

On the subject of costs, be wary of Sipp fees, as the saving made on funds may be given away on Sipp charges. From 1 January next year, many active fund managers are reducing their charges, so you could take the opportunity of comparing performance then. For example, to manage a diversified portfolio of non-UK equity stocks, take a look at Artemis Global Income (which has no UK equities) or pursue your interest in Invesco Perpetual Global Equity Income (which does hold UK equities within its make-up).

You are highly reliant on your own skills to pick fixed-interest holdings within your portfolio and, again, I would ask you to consider outsourcing this expertise to a manager who could add value in this highly complex area of the investment world. There are potentially difficult times ahead in the fixed-interest market, with matters such as liquidity and revised ratings, so you may feel more reassured to have this part of his portfolio managed by a strategic bond manager such as John Pattulo's team at Henderson or Richard Woolnough's Optimal Income Fund through M&G.

This is a critical time for you to make good choices on your portfolio which, if made correctly, will stand you in good stead for the rest of your life.

http://www.kingsfleetwealth.co.uk/