Targeting a strong return to fund care home costs

"The care is privately funded but there is a small and growing funding gap," comments our reader. "The gap is currently running at 4 per cent a year so is £4,000 a year at present, but will increase each year due to care home fees going up and our annuities' level payments. Hence our aim for a natural income yield of 6 per cent - we have no further sources of income available.

We have agreed that we should invest on a basis of five to seven years, and accept some risk to capital. We are aiming for a 6 per cent total return a year, mainly from monthly income, for five years plus on available capital of £100,000. So I have attempted to construct a portfolio that meets these objectives.

I accept that the portfolio risk profile will be fairly high, and in view of my step mother's age we would be prepared to lose 10 per cent in any given year.

My preferred kind of investments are those focused on an income yield, with prospects for capital appreciation and/or preservation. A specific investment that has influenced me is Aviva Cumulative Irredeemable Preference Share (AV.A).

My last three trades were purchases of Hansteen (HSTN), Lloyds Banking (LLOY) and National Grid (NG.)

I have the following securities on my watchlist:

Jupiter Fund Management (JUP)

ETFS Physical Gold (PHGP)

Our reader's portfolio

THE BIG PICTURE

Chris Dillow, Investors Chronicle's economist, says:

Your challenge here is to cope with what behavioural economist Hersh Shefrin has called "getevenitis".

If you put all the £100,000 into cash you would face a slow and certain rundown of capital, as care home fees exceed returns. The case for an equity-heavy portfolio is that it offers you a better chance of staying even: your hope of a 6 per cent return is reasonable in terms of total return - yield plus capital gain - in an average year.

This, though, comes at the price of the small risk of a large capital loss - quite possibly more than the 10 per cent you are prepared to lose. I'd budget on the assumption that you face a roughly one-in-six chance of losing 10 per cent or more on this portfolio over a 12-month period. This means such a loss is more likely than not at some time over the next five years.

You thus have a choice: a steady certain capital loss, versus a smallish chance of a large loss. The choice you make is, ultimately, a matter of personal taste.

There is, though, one big danger in your current position: what would happen if you do suffer a big loss? There are two possible reactions, both of which would be dangerous.

One would be to try to break even by taking on more risk, shifting to more speculative stocks. This would be dangerous simply because history tells us that such stocks tend to do badly on average over the long run. This is because investors overestimate their ability to spot great growth, and because they overpay for the small chance of big returns.

The other dangerous response would be to infer that you were taking on too much risk, and to shift into cash or bonds. This might, in effect, crystallise your losses, as it would deprive you of the chance of profits if shares recover - to the extent that their falls were due to excessive pessimism or to increased risk aversion.

My point here is that your asset allocation should be time-consistent: can you stick with it in the face of losses? If the answer is yes, say, because the losses merely mean smaller bequests then this strategy is fine. If not, think about taking a more cautious approach, with more bonds or cash.

David Liddell, chief executive of online investment adviser IpsoFacto Investor, says:

How to get the best balance of a high and growing income, without too much capital risk over an uncertain but possibly relatively short period, at a time when interest rates on cash and bonds are particularly low, is a question facing a number of people with elderly relatives experiencing rising care costs. One route would be to consult a specialist annuity provider and use, say, half the capital sum to lock in an index-linked income return with some of the capital returned in the event of early death. The balance of the capital sum could be invested for capital growth.

Alternatively, you could create an annuity-like product yourself, with a series of bonds that would mature over the coming years. But this is likely to be fiddly and may not provide the certainty required. Your solution is to have an interesting mix of preference shares, income from leasing aircraft and exposure to a variety of equities. Overall, the portfolio produces income of £5,600 or 5.4 per cent, just under the required 6 per cent, but sufficient to cover the funding gap with some room for growth.

Sarah Lord, managing director of Killik Financial Planners, says:

"One of the key aspects of planning for long-term care is that the length of time that care is required for is unknown, and therefore the portfolio could potentially be required for a number of years.

If you are concerned about being able to sustain the level of income required to meet the shortfall over the longer term then one consideration would be to use some or all of the portfolio to buy an immediate needs annuity. This is where a capital sum is handed over to an insurance company, which in return for the capital provides an income, typically direct to the care home, to cover some or part of the care home fees. The advantage of this option is that it provides security in knowing that the fees will be paid.

The disadvantage is that it is unknown how long the fees will need to be paid, so if death occurs relatively soon after buying the annuity then the capital sum is lost.

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

Something else you might consider is to have more defensive equities.

Defensive stocks do not prevent losses: even the best defensives would lose money in a serious market downturn. They would, though, usually fall by less than the general market. And history tells us that they offer good average long-run returns: this could be because their risk of underperforming a strongly rising market makes them unattractive to some fund managers.

Luckily, you already own some of these: 3i Infrastructure (3IN), Lindsell Train Global Equity* (IE00BJSPMJ28) and CF Woodford Equity Income Fund* (GB00BLRZQB71) fit the bill, as does National Grid. This, though, is offset by your holding of the Doric Nimrod funds: whatever other merits aircraft leasing has, it is not a defensive industry.

Perhaps greater holdings of defensive equities would meet your twin objectives of moderating potential losses while giving you the chance of reasonable returns. This would come at the price of missing out on a big market rally, but perhaps that's a price you can pay.

David Liddell says:

I can see the thinking behind this portfolio but my concern would be with the stock-specific risk in Aviva and the amount of income - nearly 75 per cent - which comes from the two Aviva securities and the two Nimrod aircraft leasing funds. These may be relatively illiquid and the income from the preference shares will not increase.

Although the Aviva preference shares have performed well, however unlikely it may seem, it is always possible that such a life company could blow up in some way. As regards the Nimrod funds, there must be a certain element of substituting income for capital here, and although this may be a perfectly sensible thing to do with this portfolio, the exposure seems too much.

I also don't think it's necessary for this portfolio to take on individual equity risk with National Grid, which has already performed so well and Lloyds - although it is true that the latter has growing income capability. A similar yield could be obtained from a fund or equity income investment trust.

I would look to cut the Aviva preference shares and Nimrod holdings at least in half. The yield could largely be made up by bringing in some higher-yielding investment trusts or exchange traded funds (ETFs), for example, Murray International* (MYI), Investors Capital Trust (ICTA) and iShares UK Dividend UCITS ETF** (IUKD).

You could also make up the yield by reducing the lower-yielding funds - Scottish Mortgage* (SMT), Fundsmith Equity* (GB00B4MR8G82) and MFM Slater Growth (GB00B7T0G907) - which have good performance records but may also be subject to volatility greater than the market. Replace them with funds such as Edinburgh Investment Trust (EDIN) and Temple Bar (TMPL), for example. The income might be slightly reduced, but it would have more ability to grow, and the portfolio would be more balanced.

Rachel Winter, private client broker, Killik & Co, says:

I'm concerned about the high equity weighting in this portfolio. Although equities are great for long-term growth, they can be volatile and therefore I don't think this portfolio is suitable for an investor who would not feel comfortable losing more than 10 per cent in any given year. I suggest including some corporate bonds, which would add stability and generate income. There are many attractive bonds on the market with maturity dates of five to seven years, which fits perfectly with your proposed timeframe.

The lack of diversification is also worrying. Over 45 per cent of this portfolio is invested in financials, which would likely be one of the worst-affected sectors in the event of a yes vote in the upcoming referendum on whether to leave the European Union. Furthermore, 40 per cent of the portfolio is invested in a single company, Aviva. This company may have a good track record, but any unexpected bad news about it could devastate your portfolio. I generally avoid investing more than 10 per cent of a portfolio in a single company, and when investing in individual equities I aim to select a diverse spread of at least 10 different ones.

Lastly, the Doric Nimrod funds, which are involved in airplane leasing, are only listed on the Specialist Funds market of the London Stock Exchange. This means they are aimed at sophisticated or professional investors.

* IC Top 100 Fund

** IC Top 50 ETF