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I want to draw 3 per cent from £450k at age 60

Our reader has an equity heavy investment portfolio but needs to put this in the context of his total wealth in order to make better decisions for his retirement.
November 7, 2014

Sanj is 53 wants to retire at 60. His priority is to preserve the £450,000 capital that he has built up by investing over the past 20 years, with a view to taking 3 per cent income from the portfolio in seven years' time. He has been using his individual savings account allowance to build this portfolio.

He expects to receive a slightly reduced annual income of £12,000 from his workplace final salary scheme when he takes early retirement at 60. He also has a mortgage-free buy to let property worth £500,000, giving £40,000 rent. He has £15,000 in index-linked bonds and fixed term deposits of £180,000 earning 5.5 per cent interest.

Reader Portfolio
Sanj 53
Description

Retirement income portfolio

Objectives

Preserve capital

 

SANJ'S PORTFOLIO: TOTAL VALUE £450,353

Name of holding%Name of holding%
Baillie Gifford Japan Trust (BGFD)3JPMorgan Mid Cap Investment Trust (JMF)4
Biotech Growth Trust (BIOG)3Murray Income Trust (MUT)4
BlackRock Frontiers Investment Trust (BRFI)2New City High Yield Fund (NCYF)1
City Natural Resources High Yield Trust (CYN)2Strategic Equity Capital (SEC)0
European Assets Trust (EAT)9Standard Life Investments Property Income Trust (SLI)3
Ecofin Water & Power Opportunities (ECWO)1Scottish Oriental Smaller Companies Trust (SST)10
Fidelity China Special Situations (FCSS)2Templeton Emerging Markets Investment Trust (TEM)2
Finsbury Growth & Income Trust (FGT)3TR Property Investment Trust (TRY)2
Hansa Trust (HAN)2Utilico Emerging Markets (UEM)2
Herald Investment Trust (HRI)3Lloyds Banking Group (LLOY)21
Henderson Smaller Companies Investment Trust (HSL)3Victoria Oil And Gas (VOG)1
International Biotechnology Trust (IBT)4Royal Bank Of Scotland Group (RBS)4
IShares £ Corporate Bond Ex-Financials UCITS ETF (ISXF)5Asian Citrus Holdings (ACHL)1
JPMorgan Japanese Investment Trust (JFJ)3TOTAL100

 

Chris Dillow, the Investors Chronicle's economist says:

Although you say you are unwilling to take too much risk, this portfolio is risky.

One reason for this is simply that consists almost entirely of equities and any basket of shares - even one as well diversified as this one - carries market risk; the danger that if the global market falls significantly it will take almost all shares down with it. Even over an investment horizon as long as seven years, this is a considerable risk. Assuming an average expected real return of 5 per cent a year with a standard deviation of 15 percentage points, there's a roughly one-in-seven chance of you losing something by the age of 60. And there's around a 6 per cent chance of you losing 20 per cent.

What's more, there are two particular risks you're taking. First, you're making a big bet on banks: Lloyds and RBS represent almost a quarter of this portfolio. This isn't merely a play upon UK banks. If there's a financial crisis anywhere - such as a re-emergence of the euro area debt crisis - it will hurt Lloyds and RBS simply because global banks are interlinked.

Secondly, you have big investments in small cap funds: Scottish Oriental's, Henderson's and European Assets Trust. These expose you to cyclical risk because small caps tend to do worse than others in economic downturns. With the health of the euro area and several emerging markets in doubt, this is big exposure.

Now, maybe these bets are worth taking. It's possible that if the euro area avoids a recession or debt crisis and if China doesn't slow down very much there'll be a relief rally and these assets will do well. Just be aware that these are the risks you're taking.

There are, though, two things that make me more relaxed than I'd otherwise be about these risks.

One is that you say you're using your Isa allowance. This makes a difference. Seven years of investing £15,000 a year would give you another £100,000 even if shares only move sideways. This alone would raise your retirement income by £3,000 per year.

Secondly, your equity portfolio is only a small fraction of your total wealth. If we consider your cash, buy-to-let property and final salary pension altogether, it comprises less than 30 per cent of your overall assets: a pension income of £12,000 has a big capital value, remember!

Most people would consider such equity exposure on the low side. I would agree, subject to a caveat. This is that over the longer-run there is a high correlation between BTL investments and equities simply because both are plays upon the state of the economy: in a recession, you'll see the capital and perhaps the rental value of the house decline as well as seeing losses on equities. This risk is exacerbated by your exposure to banks; if they get into trouble, so too will the property market.

In this context, you must focus upon the big question: how much income do you need in retirement? Your aim of taking 3 per cent of the equity portfolio in income is perfectly feasible - if anything modest. Right now, this would give you £13,000. Adding in your pension, rent from the BTL and assuming a 3 per cent return on that cash would give you a total income of around £70,000. Is this sufficient? Or too little? Or more than enough?

The answer to this question should influence what you do. If it's not enough, then it's worth holding onto this portfolio.

If, however, it is more than enough, then try to shift into cash; even at today's low rates, the better savings accounts should more or less cover inflation even for a top-rate tax-payer. Why take a risk you don't need in the hope of getting an income you don't need?

 

Adrian Lowcock, an independent investment adviser, says:

Overall your situation looks pretty good. You can achieve your 3 per cent income target without the need to take unnecessary risks. Plus, with seven years to go until you want to retire you have enough time to make changes and build on your already strong position.

In this climate your fixed deposits and inflation linked bonds have an attractive yield. However, once these products mature it will be very difficult to replicate the 5.5 per cent yield. The best rate on offer today is a five-year bond with Vanquis Bank that yields 3.01 per cent. This is in line with your income objective and the money could be released by the time you are 58, a few years ahead of your planned retirement date.

However, in retirement the yields on cash deposits are likely to be lower because you will not be able to lock them in for as long. Even when interest rates do rise, and it might not be as soon as expected, it is likely that they will not rise far so returns on cash are likely to remain low for a long time. Even so locking in at 3 per cent for five years has its risks as inflation could well be higher in the future.

Taking all of this into account, I feel some of the fixed deposits could be better used to top up your pensions ahead of retirement. You can place up to £40,000 per year into a pension (including any contributions made to your final salary pension). With changes to tax rules contributions to pensions are set to become much more accessible and tax efficient.

Next to consider is the share portfolio. I can see you clearly favour investment trusts with a few individual shares added to the mix. Investment trusts offer an excellent way to diversify a portfolio and provide access to experienced investment managers. However, because they are traded like shares they tend to be more volatile than their open-ended equivalents.

In addition to that the share portfolio has a barbell approach - a mix of high risk and lower-risk assets. Some are not suitable for a cautious investor wanting to avoid risk, while the others offer good diversification. Some funds and stocks offer attractive yields and others pay out no income. On the whole the income generated from this approach is a drag on the overall yield of your investments and is some way off your 3 per cent target.

Taking your final salary pension early is a big decision and it may be possible to defer this a year or two. It is a case of crunching the numbers. Could you make do on income from other sources and would you be better off delaying it? Your health will be a big factor in this, the healthier you are the better as delaying receiving income payments from the pension for a few years will not be significant. It is well worth checking this out to make sure you get the best deal for your situation.

The buy to let property offers great diversification and stable income to your portfolio, but the costs of running a property can be high even with the mortgage paid off. Likewise tenants come and go and properties can remain unoccupied for long periods. It is therefore important to factor all these considerations and costs into the long term income generation of the property and not rely on the headline gross yield. In addition, it is important to remember the income earned from the property is taxable.

I suggest taking three steps to improve your overall situation:

 

• Buy to let

Decide what future expenses are likely to arise over the next 10 years and your expectations of rental income growth. Create a budget plan to identify what the actual cash flow is from the property and put some money aside for ongoing and future costs. Prepare for the worst and hope for the best.

 

• Pension contributions

If possible maximise your pension contributions over the next seven years either from income, rental income or deposit savings. Putting more money into a pension gets tax relief so could boost your overall savings significantly. You could either contribute to your company pension or take out a self-invested personal pension (Sipp). This could be well worth seeking advice on to determine what is the best situation for you as well as determining whether you should take your final salary pension early.

 

• Portfolio

Restructure the portfolio to focus more on income generation. Capital preservation is important to you and an income portfolio is better at protecting capital over the long term. Of course there are risks when investing and in the short run capital values may be volatile. In the meantime your portfolio will generate an income which can be reinvested until you retire. I would suggest no more than 20 holdings well diversified across global equities, bonds and property. Stripping out the specialist funds including the biotech holdings and single company shares and replacing them with equity income and fixed income unit trusts will help reduce the overall volatility of the portfolio and boost the income generated from it. A yield of 4 per cent is achievable and you can still benefit from potential future growth. Make sure as much of your share portfolio is inside Isas as possible to protect you from paying higher rate tax on the dividends. This will be most beneficial for unit trust bonds funds where the income is received gross of tax and inside an Isa will be completely tax-free.