Tidy your Isa to produce 4 per cent yield

READERS' ISA PORTFOLIO

Chris Dillow, Investors Chronicle's economist, says:

I'm surprised that you retired without having a good idea of what your required income is; we should only stop working when we are confident that we can live off our savings.

Luckily, though, this oversight shouldn't prove costly. On the reasonable basis that equities give an average annual return of around 5 per cent a year in real terms (comprising just under two percentage points of real growth and just over three of yield), your Isa portfolio should give you an income of around £33,000 per year on top of your final salary pension.

What I mean here is that you can create your own income simply by selling some funds. Doing so, in effect, means you are creating your own dividends. If shares rise 5 per cent a year, you can withdraw 5 per cent while preserving your capital. And you can do so tax free from your Isa. You don't need so-called income funds. All your funds are in effect income funds.

Of course, the danger with this is that if the market falls you can only get that £33,000 by eating into your capital. But you have some protections against this danger. Your other pensions should give you a decent income in four years’ time; your cash holdings offer some diversification; and as you can live on £50,000, you might not need to cash in as much as £33,000 per year from your Isas.

If all these are insufficient protection, remember that there is nothing wrong with running down one’s wealth when one is older.

There are, though, three problems here.

First, while you are very wise to switch into ETFs in the trading account, you still hold a lot of actively managed funds in your Isa. The problem with these is fees. A charge of 1 per cent a year over and above the charges on trackers might not seem much. But over the long run, it compounds horribly.

Second, there is - as you say - a lack of diversification here. To a large extent, this is not your fault at all but a simple fact about global stock markets; they are usually highly correlated with each other and so rise and fall together. Despite this, I suspect there is a case for combining UK funds with some overseas ones (especially US or emerging markets), This is partly as a rough hedge against a fall in the pound: such an event would raise import prices and your cost of living, but it would also increase the sterling value of overseas shares. Also, doing so would be insurance against the risk that the UK and Europe suffer the sort of long-run stagnation that Japan did in the 1990s.

Third, you say you've been switching from your underperforming funds to your better-performing ones. While selling losers is a decent idea, I'm wary of chasing winners. Granted, momentum in individual shares means that recent good fund performance can persist for a while, but the evidence suggests that picking winning funds is very difficult, not least because only a small minority have genuine skill.

These problems, though, have a simple solution. When you are creating your dividends by cashing in some of your Isas, do so by getting rid of the funds with higher fees. In this way, you'll shift towards a low-cost portfolio.

Adrian Lowcock, an independent investment adviser, says:

You have already achieved a lot with your investments and it is now just a case of tidying up the portfolio to reflect the change in your circumstances - ie, you are now looking for a retirement income from your investments.

The Isa portfolio is the best place to start for income. There is no extra tax to pay on any income received from Isas and no need to declare the income on your tax return.

First of all you should continue to fund your Isas for the next few years. I recommend keeping the cash balance at around 12 months' expenditure, say around £60,000. In addition, you should also look to bring the exchange traded fund (ETF), investment trusts and direct share portfolio under the Isa umbrella. This would allow for an additional £143,000 to be placed into Isas, with a personal allowance of £15,000 per year. That equates to nearly five years of Isa contributions and roughly £6,000 in additional income.

I have reviewed your existing Isa portfolio to achieve the income you require as soon as possible and included suggestions for this year's Isas if you have not done them already. Achieving £40,000 income from the Isa portfolio alone is going to be difficult, stock markets have performed well in recent years and the yields on shares while still attractive are not as high as they once were. However, I have constructed a portfolio which will initially provide around £28,000 income but also offers the potential for that income to grow.

ADRIAN LOWCOCK'S SUGGESTED NEW PORTFOLIO

The first step is to reduce the number of holdings in the portfolio, 40 is way too many. I suggest no more than 20 and have settled on 15 in this instance. I have sold off holdings that do not produce some yield in order to come close to generating the income required.

To achieve the high income I have added equity income funds in Asia, Emerging Markets where dividend yields are higher and expected to grow in the long term. I have also included some US and European income funds to provide a globally diversified equity income portfolio. The US has some of the most reliable dividend payers in the world and Europe is full of globally-focused businesses.

Finally, I have introduced a number of pure bond funds. While there is much debate on the future of bonds they do provide some additional yield and remain attractive for income seekers in the current climate. Good managers should help protect investors capital whilst delivering a decent income. Bond income is less likely to fall or rise than equity income and provides some diversification to the portfolio.

In addition to this I have replaced the property exposure and increased the weighting. Property is best held in closed ended funds, ie investment trusts where liquidity does not cause problems.

With regards to the Invesco Perpetual High Income fund I have reduced the exposure. New manager Mark Barnett is no doubt an experienced and capable manager but he faces new challenges in running such a large fund portfolio so it is best to reduce the risk. At this point in time I don’t see it as necessary to add Neil Woodford's new fund. Better to let the dust settle for the time being and ignore the hype although I am confident he will do well.

I have introduced Marlborough Multi Cap Income to add some small and mid-sized company exposure to the portfolio, which being dominated by equity income is a bit heavy on the larger company’s funds.

My further suggestions would be to top up your income from your shares, ETFs and investment trusts. It is clear you don't want to own individual shares and if the reason for holding Falkland Island Holdings (FKL) and Land Securities (LAND) no longer exist, don't wait to sell - just bite the bullet and switch into an income-producing fund. You could also convert the ETFs into generating an income also using funds.

You could get around £100,000 of your cash working for you now although any income generated may be taxable it could bring in around another £4,000 and potentially grow as well. Then each year you could carry out a bed and Isa, switching funds into the tax-free wrapper. By doing this you would not be too far off the upper end of your income target.