Maximising retirement income and depleting capital

ANONYMOUS PORTFOLIO

Source: Reader and Investors Chronicle

OPTIMAL CONSUMPTION PATH

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

You ask what sort of income you could expect from this portfolio. The answer is: a lot. I use a working assumption that equities will return - on average - 5 per cent per year in real terms. This implies that, on average, you should be able to take slightly under 5 per cent of this portfolio in income each year while preserving your capital. That's over £100,000 per year - and it'll rise with inflation.

But of course, you don't need to preserve your capital. You can run it down. You could, therefore, get an even bigger income than this. I reckon around £150,000 per year if returns are average and you live to your mid-80s.

However, there are two big ifs there. One is equity risk. Your capital might be eroded by falling equity prices, rather than by your spending. I'd budget on the assumption that there's around a one-in-seven chance of losing 10 per cent or more over a five-year period. The other risk is longevity risk - the possibility that you will live so long that you'll outlive your wealth.

In principle, there is a perfect solution to these twin risks: annuities.

I suspect, though, that you don't want to use these. The obvious reason for this reluctance is simply that rates are so low now. But this might change in the next few years. If it does, consider partially annuitising your wealth.

There's another reason not to annuitise. It's that there's a case for spending more now even at the expense of cutting back later. This is because the happiness you get from spending is likely to be higher now than it would be in future. Big foreign holidays are more fun when you are fit and healthy than when your mobility is limited (and health insurance isn't so prohibitive either!) You can only enjoy fast cars while your eyesight is fine, or concerts while you've got your hearing. In economists' jargon, the marginal utility of consumption is greater when we're young.

What's more, spending on the right things now can create future happiness. Spending on music, books and art now can provide a love of culture in future, and spending on holidays and nights out can build up a stock of happy memories which you can cherish in your dotage. In this sense, spending can build up consumption capital. It might well be, therefore, that your optimal consumption plan consists of big spending now.

This is not the sort of thing you hear from conventional financial advisers. There's a good reason for this, and a bad. The bad one is that advisers get commission from your savings, not from your spending. The better one is that there are dangers in spending now. You might acquire expensive habits, for example if you get a taste for fine wine. Or you might find that spending more time together causes you to get on each others' nerves and divorce: the numbers of 'silver separators' have risen sharply. (Sorry to mention this, but there's no romance in economics). In these cases, high spending now would create future liabilities rather than assets - high spending habits or bad memories.

My point here is that it is pretty impossible to achieve an optimal consumption path. Don't try to optimise. Just be aware of the twin dangers of spending too much and too little.

PORTFOLIO TIPS

Chris Dillow says:

As for the shape of this portfolio, I would usually say that it is overdiversified; you have so many shares that, in effect, you have a tracker fund. However, this criticism is tempered by the fact that you have largely avoided high-cost actively managed unit trusts and that you've a bias towards defensive stocks, and these tend to do well over time.

Lee Robertson, a chartered wealth manager at Investment Quorum says:

Within the portfolio it appears you have around 55 per cent invested in the largest 10 holdings, which does seem a little high-risk. However, in terms of sectors we favour pharmaceuticals, financials, tobacco, technology and consumer discretionary, which means we are broadly very much in favour of your current holdings.

Within sectors such as utilities we would be more cautious, given that they are always vulnerable to government or regulatory changes. Other stocks within your portfolio that could continually benefit from government incentives to build more houses would be businesses such as Persimmon and Crest Nicholson.

The severe fall in the crude oil price has affected the energy sector and you own some of the leading oil companies, including Royal Dutch Shell and Tullow Oil. However, this is good news for the consumer so it would be worth considering investments in companies such as Restaurant Group and Cineworld, which will benefit from an increase in consumer spending.

TAX PLANNING TIPS

Lee Robertson says:

Your wife might consider moving her AVC money to a low-cost Sipp, which would give more scope for investment opportunities, tax-free withdrawals and drawdown options. Income could therefore be controlled and returns could be higher than current annuity rates.

You could also consider moving your defined-contribution pension funds from your employer to a low-cost Sipp for increased fund range and flexibility.

Placing your pension funds into drawdown will enable intergenerational transfer, thereby adding to the new flexibilities.

You may wish to consider moving some of the funds into an Offshore Single Premium Bond. This will provide up to 5 per cent tax-deferred withdrawals for 20 years, and give you gross roll-up of the invested capital and can again be arranged for intergenerational transfer if this is a requirement.

Isas are an important tax-efficient investment vehicle and I would advise you utilise your individual annual allowances as fully as possible. We would suggest a 4 per cent income stream is achievable with your Isas.

The combination of pension/Sipp, Offshore bond and an Isa will give you lots of flexibility within your withdrawal strategy as you will have an income profile combination of tax-free, tax-deferred and taxed as earned income. This, with careful planning, should enable you both, while utilising your personal allowances, to remain basic-rate taxpayers with the possibility of an even lower applying tax rate.

SHOULD I TAKE TAX-FREE CASH NOW?

Our reader says: "I would like to your opinion as to whether it would be preferable to take the 25 per cent tax-free element of my pension as a one-off lump sum, or as tax-free income on each withdrawal. Taking it as a one-off lump sum has the advantage of ensuring that we get the 25 per cent and that this benefit is not lost to some future government change in rules. The downside is that any income generated would be subject to income tax, and any investment growth would be subject to capital gains tax, both of which would be avoided by leaving the 25 per cent in the pension wrapper and taking it as tax-free income on each withdrawal."

Chris Dillow says:

As a general rule, I'd advise against taking the tax-free lump sum for now, unless you have a pressing need for the cash. It's better to keep as much money in tax shelters for as long as possible. A more tax-efficient way of getting income would be to ensure that you make full use of your capital gains tax (CGT) allowance; it's for such tax planning that financial advisers have a genuine use.

Lee Robertson says:

I note your concern that future legislation might restrict the availability of tax-free cash, but the direction of travel is currently to give more access to pension capital as opposed to less. However, this is a legitimate concern, particularly the tax element. Moving from the tax-advantaged pension environment obviously has both advantages and disadvantages. If you do move it you should consider other tax-efficient investment vehicles, assuming you don't wish just to spend it.

Danny Cox, a chartered financial planner with Hargreaves Lansdown says:

Perhaps the first question is whether there is the need for the cash, for example to pay off debt, improve reserves or gift, and part of the answer to this question will depend on what other cash is being generated from other pension schemes. For a healthy person, it normally makes sense to maximise the income from defined-benefit pensions and not take the cash - the guaranteed index-linked pension income usually has a much bigger lifetime value than taking as a lump sum.

It is a safe assumption that future governments will not tinker with the tax-free cash entitlements already accumulated. Those with pension benefit values over £1m could see the potential for a reduction in tax-free cash, but as we have seen with other legislative changes, there should be the opportunity to protect what has already been accumulated.

Assuming the tax-free cash is not needed, dividing your pension pot into segments and taking a portion of tax-free cash each year as quasi income makes a lot of sense and saves income tax compared with taking the full amount as taxable income. The way this works is to think of your pension pot as a loaf of bread where you take a slice each year. Each slice has a 25 per cent tax-free cash portion. As the value of the pension rises or falls from year to year, the value of each slice changes, but you are still entitled to 25 per cent of each slice tax-free.

If you did take the tax-free cash in one go, sheltering this in an Isa would only take three tax years between you and your spouse and then the income and gains would be free from further tax.

Andrew Tully, pensions technical director at MGM Advantage, says:

Historically, there was a significant difference in the tax treatment of death benefits between leaving benefits untouched and taking them (so leaving untouched was key). That is being removed from 6 April, so the key now is tax planning.

Generally it is best to leave funds in a pension until they are needed. The tax-advantaged environment of a pension is unmatched - largely tax-free investment return, no tax on death before age 75 and no inheritance tax issues. Even on deaths after age 75 people can use tax planning to leave funds/income to people who are less likely to pay high income tax: for example, split benefits between grandchildren.

This also has the potential advantage of funds growing in the meantime, and therefore the tax-free element being higher. For example, if I had £200,000 in my pension in April 2015 and I took all my tax-free cash upfront I would get £50,000 tax-free. If I took half (£100,000 with £25,000 tax-free) and left the remainder for five years by which time it had grown to £120,000 - I would then get £30,000 tax-free (so £55k in total rather than £50k). A simplistic example but leaving and gradually withdrawing funds as and when needed may well result in a higher tax-free payout.

The downside mentioned is to take tax-free cash while they can before rules are changed. And I have some sympathy for that as removing/reducing tax-free cash is a perennial rumour. However I think if that happened (and I don't expect any imminent change) it is likely that tax-free cash entitlements built up would be protected in some way, rather than there being a blanket change which also affects existing savings.

In my view, the tax planning angle is paramount and funds should be left in the pension wrapper until they are needed. However, this is a balancing act and demonstrates the need for financial advice, which can take into account the individual customer's position.