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How should I invest my £500,000 Sipp for income?

Our reader is starting from scratch with his portfolio and wants to generate £20,000 income a year
June 20, 2014

Richard Hoar is 67 and has been investing for 20 years. He requires £20,000 income from his pension, starting immediately, while maintaining the value of the fund in line with inflation. He has £500,000 to invest on a "clean slate" basis in a self-invested personal pension (Sipp). This money comes from the sale of a property which was previously held in a small self-administered scheme (SSAS).

He has put together a suggested £500,000 Sipp portfolio from which he will take income via drawdown and wants to know what Investors Chronicle's experts think of it before investing.

"I have been willing to embrace risk when earning a wage, but I suppose I must be more cautious now," he says. "In the past I have speculated with shares but now I must get serious. I have bought Legal & General and the Fundsmith Equity Fund. However, I may swap Fundsmith's current fund for the new Fundsmith Emerging Markets Fund. I also need inflation protection. Would this portfolio provide this?"

Reader Portfolio
Richard Hoar 67
Description

£20,000 retirement income plus inflation protection for capital

Objectives

Self-invested personal pension

Richard's suggested Sipp portfolio

CompanySectorTIDM/ISINTotal
UnileverChemicals & foodULVR0
PearsonPublishingPSON0
BPOil & gasBP£10,000
Scottish & Southern EnergyUtilitiesSSE£10,000
National GridUtilitiesNG£20,000
United UtilitiesUtilitiesUU£10,000
Centrica (British Gas)UtilitiesCNA£10,000
Severn TrentUtilitiesSVT£5,000
PhoenixInsurancePHNX£10,000
ResolutionInsuranceRSL£20,000
Legal & General*InsuranceLGEN£20,000
GlaxoSmithKlinePharmaGSK£10,000
AstraZenecaPharmaAZN£5,000
HSBCBankingHSBA£10,000
Standard CharteredBankingSTAN£10,000
Fundsmith Emerging Equity TrustEquitiesFEET£50,000
Fundsmith Emerging T Inc NAV*EquitiesGB00B4M93C53£100,000
BAE SystemsAerospaceBA£10,000
VodafoneTelecomsVOD£40,000
AshmoreAsset managementASHM£20,000
FresnilloMiningFRES£20,000
VedantaMiningVED£20,000
IcapFinanceIAP£20,000
iShares Corporate Bond Fund ex-fin UCITS ETF ISXF£10,000
Manx TelecomTelecomsMANX£10,000
iShares Corp Bond Fund UCITSInvestment trustSLXX£5,000
Temple BarInvestment trustTMPL£5,000
BlackRock Commodities Inc ordInvestment trustBRCI£5,000
New City High Yield ITInvestment trustNCYF£5,000
GCP Student Living ordInvestment trustDIGS£5,000
Henderson Far East Income ordInvestment trustHFEL£5,000
Finsbury Growth & Income TrustInvestment trustFGT£10,000
Aberdeen Asset ManagementFinanceAND£10,000
Total  £500,000
Cash  £30,000

*Richard already owns

 

Chris Dillow, the Investors Chronicle's economist, says:

This portfolio will protect you from expected inflation, but not unexpected inflation.

It will protect you from expected inflation because - by definition - this should be already embedded into share prices. Over time, shares should rise by more than inflation, and enough to give you the income you want.

To see this, let's start from the fact that markets expect Retail Prices Index (RPI) inflation to average 3.1 per cent a year over the next 10 years; Consumer Price Index (CPI) inflation should be 0.5-1.0 percentage points lower. And let's assume that the economy grows by around 2 per cent a year in real terms. This implies a rise in money GDP of 5.1 per cent a year (let's ignore differences between RPI inflation and the GDP deflator). Let's make some further assumptions: that profits rise in line with GDP; that dividends rise in line with profits so the payout ratio doesn't change; and that shares are fairly valued now so the dividend yield won't systematically change. These assumptions, I think, are reasonable for the long term even though they won't hold year to year.

These imply that share prices will rise by 5.1 per cent a year in nominal terms, and that total returns will be around 8.4 per cent; the yield on the All-Share index is now 3.3 per cent. This gives us a return after RPI inflation of 5.3 per cent a year. This means you should be able to take an income of a little over £25,000 per year (in real terms) from your portfolio while leaving your capital intact.

So, we have both inflation protection and your desired income.

Except that there are two problems here.

One is that we might suffer a burst of unexpectedly high inflation. Shares probably won't protect you from this because there is a strong tendency for share valuations to worsen when inflation rises; since 1997 the correlation between CPI inflation and the dividend yield on the All-Share has been 0.49. This is true even for defensives; there's also a positive correlation between yields on utilities and inflation.

The only way to protect yourself properly from unexpected inflation is to hold index-linked gilts. Doing so, though, entails a huge sacrifice of returns. Sure, holding overseas equities would protect you from inflation caused by a fall in sterling - but this is only a subset of likely sources of inflation.

My advice would be not to worry much about this problem for now, as a big rise in inflation is unlikely at a time when there's quite a bit of spare capacity in the global economy.

Our second problem is that while equity returns should be a little over 5 per cent on average, there's a lot of variation around this average. As a working assumption, you should reckon on one year in six giving you a loss in real terms of 15 per cent or more; this might seem a small chance but it is almost certain to happen at least once in the next 20 years.

You say you like risk, so you should be willing to accept this prospect: it also means there's around a one-in-six chance of a 20 per cent return in a year. And there is a case for running down your capital slightly at your time of life.

If you don't like this prospect, one thing you can do is to be disciplined about not taking an income of more than £20,000 a year. Doing this would allow capital growth in good years to cushion you against losses in bad. If you don't think this is sufficient the only option is to hold more cash - which again means sacrificing returns.

As to the general shape of your portfolio, I like that you're not incurring too many fund charges and I like the defensive bias in your stock holdings: there's lots of evidence that defensives do better than they should over the long term. However, I wonder whether 33 holdings isn't needless diversification; remember that if a share represents only 2 per cent of your portfolio, it's unlikely to make much difference to returns. If it's diversification you want, tracker funds are more convenient.

 

James Baxter, managing partner at Tideway Wealth, says:

Lowering ongoing tax liabilities is a risk-free way to improve net spendable income. In practice this means getting the right investment assets in the right tax wrappers. Pension accounts are tax-efficient vehicles in accumulation, but after withdrawing the tax-free cash, they are less tax efficient in withdrawal mode.

The new drawdown rules coming into effect in April next year widen the possibilities for this kind of planning.

• Few couples use their combined tax-free capital gains allowances.

• Dividends earned on shares held personally are worth 25 per cent more net of tax than those earned in a pension withdrawal account. Tax on dividends is effectively paid twice in pension withdrawal and this 25 per cent uplift applies whether you are a basic or higher rate taxpayer.

• Isas can pay out tax-free income and have no tax on withdrawals so they are more efficient in withdrawal mode than pension funds and give full access to capital without tax.

So rather than simply setting withdrawals around spending needs, recognise that holding shares personally and having funds in Isas is better than having too much in a pension. Withdrawal planning for the pension then becomes more a question of how quickly do I withdraw and reinvest, elsewhere?

This will be a balancing act between paying tax now and paying tax later. Suffice to say, getting the withdrawal plan correct and making full use of the Isa and other personal allowances can save thousands of pounds per year of unnecessary tax on your retirement income and tens of thousands when emergency funds are needed, or on death.

We suspect you could be more tax efficient by taking significantly higher withdrawals now and investing surplus net income in Isas or personally with your wife, to avoid much higher tax rates on your pension withdrawals or residual fund in years to come.

With your suggested portfolio, you would be heavily focused on equities, with 96 per cent of your portfolio in equities or equity funds, and would suffer significant capital losses in any broad market correction. This would be very damaging if it coincides with an unforeseen need to take bigger withdrawals.

Lowering the reliance on equities and increasing the weighting to both bonds and funds with the ability to hedge and secure capital in a downturn would give more stable reliable returns and more capital protection. This does not have to be at great expense to overall performance, but the bonds and funds used need careful selection in order to avoid this happening.

Gilts, general corporate bond funds and broad bond exchange traded funds are now yielding very little and often less than inflation after fees; they will also be susceptible to capital losses when interest rates eventually rise. High-yield bonds can generate sufficient yield to offer a cushion against smaller rate rises (as anticipated) but are not easily accessible to the private investor without some help. Some subordinated bonds are paying around 5-6 per cent yields to redemption and more with a very high degree of certainty, and these would be a great way to lower equity exposure but at the same time generate a return in excess of both inflation and the income yield you require.

The quality and transparency of targeted absolute return funds has improved significantly in recent years and some managers can clearly demonstrate sustainable returns in excess of 5 per cent a year with very low volatility and capital preservation in a downturn.

In summary, adding these two asset classes to the pension fund, while moving some of the equity exposure out to be held personally and using high-yield bonds in maximised Isas with accelerated pension withdrawals could provide a much more tax-efficient, flexible and stable income and reserve capital base for their retirement.