Reduce your risk and rotate towards income

"My aim is to provide an income from my self-invested personal pension (Sipp) and other investments for my wife and myself when I reach 65. At that point, I intend to reduce our number of holdings, and aim for an average return of 5 to 6 per cent a year. I hope to take 4 per cent as income and let any additional gain remain as capital.

"In the next two years my employer will contribute £22,000 to my Sipp. We also have £60,000 in cash to cover any short-term shortfall and my wife has a small civil service pension of £2,000 a year.

"About 90 per cent of our investments are held in individual savings accounts (Isas).

"We are aware that generating income or asset growth involves risk. We are very equity dependent due to our need for income and growth. But we hope to make the portfolio less risky at the time I retire from which point I expect to concentrate on income-bearing investments.

"However, we realise that over time investing for growth appears more beneficial, as income can be taken from growth. In lossmaking years we could live off the cash reserve and expect to make it up in the growth years. We would like to hear your views on the growth/income balance in retirement.

"I was fortunate enough to do well in the biotech boom and sold my investment trusts focused on this area just after their initial slide. However, I have recently bought back Biotech Growth Trust (BIOG), and other recent purchases include Chelverton Small Companies Dividend Trust (SDV) and RIT Capital Partners (RCP).

"With retirement in mind I am now considering more strategic bond funds and topping up Vanguard Life Strategy 20% Equity (GB00B4620290)."

John's portfolio

THE BIG PICTURE

Chris Dillow, Investors Chronicle's economist, says:

You ask what the balance between income and growth should be. But I don't like either concept.

The problem with 'growth' assets is that they are largely unpredictable. Alex Coad at the University of Sussex has shown that corporate growth is largely random - a finding corroborated by US researchers. William Goldman's famous saying about Hollywood - "nobody knows anything" - applies pretty well to equity investing.

What looks like a growth asset can often be overpriced. For example, many investors in 2001 and even 2002 overestimated the growth prospects of technology stocks and lost fortunes.

On average, over the long run, growth stocks do badly. Over the past 30 years the FTSE 350 Lower Yield index has given a total return of 2.2 percentage points a year less than the FTSE 350 Higher Yield index. This warns us not to chase growth.

Income, however, also has its perils. A high income can be a sign of high risk, such as an economic downturn. In 2007 mortgage lenders and builders offered high income, but lost horribly in the subsequent recession. Similarly, in 2014-15 miners offered nice yields but fell badly.

This problem might also affect corporate bonds. If we get another slowdown, especially at a global level, default risk will increase, so the lower-quality corporate bonds some of your bond funds hold might lose money.

This isn't to say you should avoid income assets. If cyclical risk doesn't materialise, they can pay off nicely. Last year, for example, higher-yielding miners did very well as the risk of a global slowdown receded. It's just that this is one area where high returns come with high risk.

There is, however, another category of income asset. Some stocks are on high yields because the market thinks they've gone ex growth - often big mature stocks. But these are well worth buying. This is because the inability of investors to predict growth that causes them to pay too much for growth stocks, can also make them underestimate the potential of more mature stocks. Bigger companies often have what Warren Buffett calls "economic moats" - an entrenched market position that protects them from competition and thus allows them to grow, often by more than expected.

And you hold these. Troy Trojan Income (GB00B01BNW49) and Lindsell Train Global Equity (IE00BJSPMJ28) have big holdings in large defensive stocks.

So forget the growth/income division and consider how you should split your risky and safe assets. Risky assets are general equities and lower-grade corporate bonds. Safe assets are cash and perhaps good-quality government bonds. I say perhaps, because while these would do well if the world economy disappoints investors or risk aversion increases, they would suffer if the world economy grows better than expected.

The choice here is, ultimately, a matter of taste. As a guidepost, I'd reckon on an 80-20 split between equities and cash, which should deliver a real total return of around 4 per cent a year.

Also, consider if there are some categories of share that might outperform on average. It's here that there's a case for defensive stocks that have nice yields. Many equity income funds and investment trusts invest in these. The case for holding them is not so much income in itself, but because defensives tend to do well over the longer run on average.

Simon Bonnett, senior consultant, private clients, at Beckett Financial Services, says:

Your Sipp should have adopted the recent improvements in death benefits and income flexibility, but not all pension contracts have done this so check it.

Also, is your pension death benefit nomination up to date - what happens if you and your wife die together? Make sure the basics are established correctly and considered annually, and include the nominations for any company sponsored life insurance and pension schemes, too.

And as pension funds can now be used as a family wealth trust, the investment and income derived could last for generations so invest these accordingly.

Make sure both your wills are current as your four sons are now financially independent. And have a Lasting Power of Attorney in place to ensure finances are not hampered should the situation arise.

It's good to see that the majority of your investments are within tax-efficient structures such as Sipps and Isas. Any remaining investments outside these structures should benefit from tax-free gains as these should fall within your capital gains tax (CGT) allowance (£11,100 for the current tax year), and tax-free dividends via the annual dividend allowance. But regularly transfer investments held outside tax wrappers into Isas each year until all your holdings are in a tax-efficient environment.

With regard to a 4 per cent income withdrawal rate, academic research, notably from the US, such as Bengen in 1994, and Cooley, Hubbard and Walz in 1998, indicates that a well-managed, diversified investment portfolio should last 30 years-plus in most market conditions with a withdrawal (ie, income) of 4 per cent a year. This can be a combination of natural yield and profit.

Your portfolio should be able to provide a gross income of about £22,000. But income from your Sipp is likely to incur some tax when you start to receive your state pension, so consider the net income position you require.

Also, keep an eye on the interest you earn on the £60,000 cash and do not discount NS&I Premium Bonds as a home for this.

HOW TO IMPROVE THE PORTFOLIO

Samantha Owen, portfolio manager at Beckett Asset Management, says:

I agree that a balanced portfolio of growth and income assets can not only support a good level of regular withdrawals in retirement but also reduce portfolio volatility. The balance between growth and income depends on levels and timings of withdrawals, and having a cash buffer so you can have some flexibility is a wise decision.

In a low interest rate world the sort of yield offered by Paragon Group of Companies 6% NTS 28/08/24 (PAG3) looks attractive. But bear in mind the nature of the issuer's business - buy-to-let mortgages - and that it is an unsecured bond not protected by the Financial Services Compensation Scheme. It was trading just above par at the time I wrote this, but if we saw a weaker UK economy in the wake of Brexit negotiations, then negative sentiment could affect the price of the bond and the fortunes of the issuer.

The housebuilder shares you own could also be hit by any slowdown fears as the property market is so economically sensitive.

You have a couple of years until retirement so you could start a gradual reduction in risk, banking some profits and reducing some of the portfolio tail. I would advocate a shift towards a larger proportion in a low-cost multi-asset managed fund such as those offered by Vanguard, but one that is seeking a slightly higher yield, which will act as the stable core. And you could have some growth holdings around the periphery, such as the biotech trust you favour, while you still take an active interest in investing.

I assume that your investments are all in tax wrappers where investment growth is free of CGT, meaning you wouldn't have any concerns about taxable gains if you were to rationalise and de-risk the portfolio as suggested.

Ben Willis, head of research at Whitechurch Securities, says:

Based on the current value of your investment portfolio, excluding cash, and based on a stated income requirement of around 4 per cent, you will be seeking to generate an annual income of £20,000 to £25,000. As far as I can see, your intention to use capital growth to provide your income needs is not required as the majority of the investment portfolio is held within Isas. As such, any income produced will be exempt from tax.

You have built up the basis of a relatively sound investment portfolio, but some fine-tuning is required to achieve your income aims. Your investment portfolio yields approximately 2 per cent and over 80 per cent of it is in equities. As you would like to reduce the risk of the portfolio and effectively double the yield, I would start by doubling your current exposure to fixed interest.

Axa Sterling Strategic Bond Fund (GB00B02Y6M37) is contributing little to the overall portfolio and offers a relatively low yield. I would sell this and significantly increase the weighting to Invesco Perpetual Enhanced Income (IPE) and City Merchants High Yield Trust (CMHY) as these provide some very high yields.

I see little point in holding both iShares £ Corp Bond ex-Financials UCITS ETF (ISXF) and iShares Core £ Corp Bond UCITS ETF (SLXX), so I would sell one and reinvest the proceeds in the other.

I suggest trying to maximise the dividend income from your equity positions. So sell any non-yielding equity funds such as Biotech Growth Trust and Baillie Gifford Japan Trust (BGFD) even though some of these have been excellent long-term positions. I would use the proceeds to bolster marginal positions such as Witan Investment Trust (WTAN) and higher-yielding areas of the existing portfolio, for example, equity income positions such as Troy Trojan Income (GB00B01BNW49) and Newton Global Income (GB00BLG2W887).

Using dividend-paying equity funds for your income needs will hopefully provide the potential for a rising income and growing capital base over the medium to long term. Positioning your investment portfolio in this way will provide the potential to generate the 5 to 6 per cent annualised total returns you seek. By adopting this strategy, you should hopefully negate any need to use your cash to subsidise income shortfalls during lossmaking years, so the cash can be maintained as an emergency fund.

In summary, increase your fixed-interest allocation, and keep the remainder of about 65 per cent allocated to dividend-paying equity positions, with a view to generating a starting portfolio yield of 4 per cent.