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64-year-old wants £20k in "natural yield" only

Although our reader doesn't want to dip into his capital, our experts think his income goal is achievable
December 19, 2014

Roger is 64 and is about to retire. He and his wife have secured £28,000 annual income from state pensions and two annuities. However, their living expenses are £45,000-£50,000 a year.

They have put together a portfolio held mostly in individual savings accounts (Isas) and self-invested personal pensions (Sipps) in order to cover the income shortfall of approximately £20,000.

Roger says: "Broadly, the intention is to live off the natural yield from the portfolio and to leave as much of the capital as possible intact for our children unless it is required for nursing home fees.

"I have structured the portfolio to include two to three years of income in cash and five years of low-risk/bond funds, with the balance in equities.

"I have dabbled with individual shares, but suffered a 100 per cent loss on one investment, so have decided that funds and exchange traded funds are the best approach for me. I note the general concern IC authors have to minimise charges, but believe the best funds justify the higher fees if they are able to beat the index."

Reader Portfolio
Roger 64
Description

Isa & Sipp

Objectives

£20,000 annual income

ROGER'S PORTFOLIO

HoldingValueTax wrapper
Cautious funds (12%)
Ruffer Total Return Acc£24,268Isa
Ruffer Total Return Acc£14,729Pension
Kames Ethical Cautious Managed Acc£42,499Pension
UK equity (23%)
Invesco Perpetual Income Acc£11,018Isa
Franklin UK Mid Cap Inc£8,538Isa
Standard Life UK Smaller Companies Trust £11,978Isa
Finsbury Growth & Income IT£21,198Pension
Franklin UK Mid Cap Inc£12,093Pension
JO Hambro UK Equity Income Acc£20,902Pension
Schroder Income Maximiser Inc£19,556Pension
Standard Life UK Equity Unconstrained Acc£20,477Pension
Standard Life UK Smaller Companies IT£5,888Pension
Unicorn UK Income Fund Inc£18,186Pension
Asia Pacific (15%)
First State Asia Pacific Sustainability Acc£21,608Isa
First State Global Em M Sustainability Acc£16,083Isa
Newton Asian Income Inc£16,513Isa
Aberdeen Asian Income IT£5,006Isa
Aberdeen Asian Smaller Companies IT£11,124Isa
Aberdeen Asian Income IT£15,128Pension
Aberdeen Asian Smaller Companies IT£8,379Pension
First State Global Em M Sustainability Acc£4,245Pension
Global equity (20%)
Newton Global Higher Income Inc£9,546Isa
Murray International Trust IT£13,401Isa
F&C Global Smaller Companies IT £15,304Isa
F&C Global Smaller Companies CULS£3,193Isa
F&C Global Smaller Companies IT £6,363Pension
Jupiter US Smaller Companies IT£20,901Pension
iShares MSCI World Inc£21,933Pension
Murray International Trust IT£4,946Pension
Newton Global Higher Income Acc£12,178Pension
Polar Capital Technology Trust IT£23,593Pension
Resources (4%)
City Natural Resources High Yield Trust IT£8,552Isa
ishares Physical Metals Gold ETC £5,848Isa
City Natural Resources High Yield Trust IT£10,169Pension
Bond funds (9%)
Invesco Perpetual Monthly Income Plus Acc£18,708Isa
M&G Optimal Income Acc£7,746Isa
Invesco Perpetual Monthly Income Plus Acc£3,152Pension
M&G Optimal Income Acc£13,601Pension
iShares Index Linked Gilt Inc£15,521Pension
Cash (10%)
Santander Cash Isa£62,139Isa
Cash in Stocks and Shares Isa£421Isa
Cash in pension£953Pension
Santander £4,316None
Individual shares (0%)
Standard Life 302 No£1,253None
Property (7%)
Share of rented property£45,000None
Total£658,153

 

Chris Dillow, Investors Chronicle's economist, says:

The good news here is that you probably can achieve your objective of taking £20,000 a year in income while leaving your capital intact.

I'd think of this as follows. The portfolio is split roughly 25 per cent in safe assets - cash, bonds and half of the cautious managed fund - and 75 per cent in risky assets, mostly equities. If we plan on a zero real return on the former and a 5 per cent real return on the latter, this gives you a total real return of 3.75 per cent a year. That's a gain of almost £25,000.

This suggests that, in an average year, you can take £20,000 out while leaving your capital intact even in real terms.

I hope that by 'natural yield' you mean total return. Remember that you do not need to own high-yielding stocks or funds to generate income. You can create your own yield simply by selling some shares. Doing so has two advantages. One is that it is tax-efficient, because you can use your capital gains tax allowance. The other is that it avoids distorting your investments unnecessarily. A high yield often means either a risky share or one with perceived poor growth prospects. Such stocks might or might not be worth buying, but investors shouldn't hold them simply for yield.

There is, however, a problem here. There isn't much margin of error. In almost as many years as not, your portfolio won't return as much as 3 per cent. This would mean you can only get that £20,000 by eating into your capital. And there's around a one-in-five chance that such an income would be accompanied by a 10 per cent fall in your total wealth.

You could mitigate this problem by reducing your equity exposure. However, this entails a sharp trade-off. On the one hand, the more bonds or cash you hold, the less chance you have of suffering a big loss. But, on the other, the lower will be your income. In this sense, you face a choice. A big cash or bond weighting gives you a very high chance of a small erosion in your wealth as you eat into capital to create a £20,000 income. But a big equity weighting gives you a bigger chance of preserving your capital but at the cost of a bigger chance of a big drop in wealth.

One solution to this dilemma might be to regard equity risk in the same way that you regard the risk of needing nursing home fees. If the latter materialises, your children get a smaller bequest. Why not adopt the same solution for equity risk?

Such a solution should be attractive because, of course, you (or your children) should with average luck be well-rewarded for taking this risk. Assuming you have another 20 years before you join the choir invisible and that you avoid the need for nursing care, there's around a one-third chance of them copping for over £1m. They might think this a fair exchange for the chance of a lower bequest.

I'd add a word of warning here about your bond funds. Bond funds are not safe. They carry price risk. Many readers might think that, with bond prices as high as they are now, this risk is substantial. I would, however, justify holding them on two grounds.

One is that they might well protect you against short-term equity risk. There are many ways in which equities might fall but bonds do well - for example, if investors' appetite for risk or expectations for growth declines.

The other is that they protect us against the risk of prolonged secular stagnation. If the economy grows slowly for many years, equities will disappoint while bond prices would probably stay high.

Despite these merits, however, you might want to consider shifting to holding bonds directly. Although the better quality ones offer low returns, they at least offer guaranteed returns if held to maturity. The same cannot be said for bond funds.

 

Lee Robertson, a chartered wealth manager and the chief executive of Investment Quorum, says:

Your £658,000 portfolio is split between a pension, Isa, property income and cash deposits. In terms of the wrappers, the Isa portfolio is around 41 per cent of the overall assets while the pension is 51 per cent, so that the property, income and cash account for 8 per cent.

We very much like the diversification across geographical areas and asset classes, and the use of both open-ended and closed-ended funds. We think this portfolio is very well positioned to deliver both growth and income.

Given that the values of the Isa and pension are £607,500, the assets from these portfolios will need to generate a natural yield of 3.3 per cent, net of fees, to generate your annual income requirement of £20,000. Clearly, this is achievable. However, the non-income-producing elements of the portfolio will require some restructuring, bearing in mind that any income from Isas can be generated tax-free.

Over the past few years bond yields have been suppressed by loose central bank policies and quantitative easing programmes. This has left both interest rates and bond yields relatively unattractive as an asset class for income investors.

UK commercial property has been a popular proxy for bonds given the attractive yields available, especially from those gross-paying property open-ended investment companies (Oeics) that have property authorised investment fund (Paif) status.

Read more on Paifs

But as there could be liquidity issues for this particular asset class this must be taken into consideration prior to making an investment.

We suggest that you continue your strategy of having an overweight exposure to global equity funds, particularly those that offer higher yields. Consider investing in CF Woodford Equity Income (GB00BLRZQ513) and Artemis Global Income (GB00B5VLFH80) [both members of the IC's Top 100 Funds) as well as BlackRock Continental European Income (GB00B43MZ612), Kames Property Income Paif (GB00BK6MJC43), Threadneedle Monthly Extra Income (GB0008370826), Fidelity Enhanced Income (GB00B3KB7682), SPDR S&P US Dividend Aristocrats ETF (USDV) [a member of the IC's Top 50 ETFs] and Old Mutual Monthly Income Bond (GB00B1XG7114).

Given the current poor returns on your Santander cash Isa, we suggest that you invest this money instead, unless there is a specific reason for the cash holdings.

The new fund investments could be financed by the sales of iShares Physical Gold ETC (SGLN), CF Ruffer Total Return Fund (GB0009684100), Franklin UK Mid Cap Fund (GB00B3ZGH246), First State Asia Pacific Sustainability Fund (GB00B0TY6S22), iShares MSCI World ETF (IWRD), and (IC Top 100 Funds) Standard Life UK Smaller Companies Trust (SLS) and Aberdeen Asian Smaller Companies Investment Trust (AAS). Admittedly, some of the fund sale recommendations are to accommodate higher-yielding products given your income requirements and therefore have no bearing on past performance. You will need to decide on the relative priorities of future capital growth against your income requirement.

While we have taken into account the natural yield requirements, we believe that many of the funds suggested for inclusion in the portfolio will also give scope for capital growth, so over time you should benefit from a total return strategy.

• None of this should be regarded as advice. It is general information based on a snapshot of the reader’s circumstances.