Funds for your income drawdown portfolio

A lesser-known alternative called income drawdown could be a better option if you're willing to keep a bit of risk on the table, as it lets you keep your pot invested in the stock market while taking an income from it. But just like regular investing, there are no guarantees, as the value of your investments may go up or down.

The key to successful drawdown is getting enough income to give you a good quality of life - without stripping too much meat from your pot too quickly and leaving yourself to survive off skin and bones during the last years of your life. The investments you choose for your drawdown portfolio are crucial if you want to achieve the right balance. Here we look at how to build a drawdown portfolio that is right for you, as well as highlighting common investment pitfalls that could put your retirement lifestyle under threat.

Constructing a drawdown portfolio

Your pension fund needs to service you for the remainder of your life, which thanks to improving life expectancy, could be more than 20 years from the point of retirement.

Because of this, most advisers say the majority of your portfolio needs to be held in riskier assets to give you growth - rather than lower volatility ones. But the right mix of investments should be tailored depending on your age and health, which are good indicators of how long you have left to live.

Jason Hollands, head of business development at Bestinvest, says a moderate risk balanced asset allocation might be 50 per cent equities, 25 per cent bonds, 10 per cent property, 10 per cent absolute return funds and the 5 per cent in commodities.

James Baxter, partner at Tideway Wealth, warns being over-exposed to equities is a mistake, as even the most defensive equities and funds can fall 20 per cent or more in a bear market. If a market drop occurs at the start of your drawdown period, it could be difficult to recoup. Following a 20 per cent fall, you need a 26 per cent return just to get back to your starting position.

Mr Baxter recommends investing 33 per cent in bonds directly, and then splitting the rest of the portfolio between absolute return and equities.

But Ben Yearsley, head of funds research at Charles Stanley, disagrees. "If I was going into drawdown I wouldn't go anywhere near bonds," he says. He prefers a 100 per cent equity portfolio with equity income funds dominating the allocation.

Most advisers agree that having a mix of around five or six funds is about the right number for a drawdown portfolio. Fewer than this might not be diverse enough but many more could be too many to keep on top of. And reviewing your portfolio every year is also a good idea - so you can rebalance it if you need to.

How much income should you take?

A flat rate annuity would probably give you a rate of about 3 to 3.5 per cent in return for your pot - but you can safely do better than this if you're in drawdown. There is a maximum limit placed on how much income can be withdrawn each year, though. The most your can take is 120 per cent of the Government Actuary's Department (GAD) rate. When you first start using capped drawdown, your pension provider will work out the maximum allowable income by using a special set of tables provided to HM Revenue & Customs by the GAD. These tables take into account your age and gender as well as the prevailing 15-year gilt yields.

The GAD rate for a 65-year-old man is currently 6.1 per cent, meaning he could take a maximum £7,320 income from a £100,000 pension, using capped drawdown.

Mr Hollands says a 60-year-old retiring could sensibly take 4 per cent of their pot as income, and as they get older they could draw more - up to about 6.5 per cent - although he warns that unless you have a short life expectancy, that level would be likely to deplete the fund too quickly.

But if you want this level of income your funds need to be making money in the right way. Mr Baxter says they should be making 5 per cent a year (after fees) as an average return. "If your funds are returning above this level then you are doing better than you would if you'd bought an annuity under any circumstance. But if they're doing worse than this - it might be better to plump for an annuity," he adds.

What funds should you put in your portfolio?

Equity income funds

Equity income funds are ideal for drawdown portfolios because they give you the level of risk you need to get growth to grow your pot, and they also provide vital yield to support your income. Mr Hollands says you need a combination of UK and Global equity income funds to spread the risk as much as possible. He says as much as half the equity portfolio could go to UK equity.

For UK funds he likes Cazenove UK Equity Income (GB00B073HX38) - with a yield of 3.77 per cent and an annual management fee of 0.75 per cent. Standard Life UK Equity Income Unconstrained (GB00B1LBSR16), which has a 3.84 per cent yield, also comes high on his list. And we like Fidelity's Enhanced Income Fund (GB00B3KB7799), which earned a place in our Top 100 Funds list 2013. It is a traditional, defensive UK equity income fund with a similar composition to the Invesco Perpetual Income and High Income funds. But it is smaller and more nimble than these huge funds. It also uses a covered calls derivative strategy whereby the fund can boost its yield to about 7 per cent by forgoing some potential future capital growth in exchange for a higher level of income.

When it comes to Global funds, Newton Global Higher Income (GB00B5VNWP12) also scores highly - making its way into our Top 100 Funds for 2013. The fund's objective is to achieve increasing annual distributions, together with long-term capital growth from investing predominantly in global securities. It focuses on sustainable dividends, reinforced by its strict yield discipline, which Newton says has given it notable resilience in difficult market conditions. It is currently yielding 4.57 per cent. For larger portfolios he also suggests cherry picking regional funds such as Standard Life European Equity Income (GB00B3L7S735), Aviva US Equity Income II (GB00BCGD4P92), and Morant Wright Nippon Yield (GB00B2R83902).

Bond funds

Depending on your risk appetite, you could also consider an allocation to bond funds. But the yield on gilts and very low risk bonds are not high enough to cut it in drawdown so steer clear. Higher yielding corporate bonds, held directly, can have fantastic yields - but they are not easy to find. Mr Baxter likes Old Mutual 6.376 Perpetual Bond (XS0215556142). "If you are confident in Old Mutual not to get into difficulty and that it will call back this bond in 2020 (Tideway are confident on both these points) this bond yields 7.2 per cent a year for the next 6 years," he says.

Strategic bond funds are another good fit for drawdown. They are more nimble and diversified than traditional bond funds and can shorten their average duration, a way of minimising volatility - which is why advisers tend to prefer them. Mr Hollands likes the TwentyFour Dynamic Bond fund (GB00B5LHHR01), which covers the "full fixed income gamut". It's returned 9.94 per cent over the past year and is currently paying a 6.4 per cent yield. The TER is reasonable at 1.36 per cent.

Commercial property

If you're looking for some income diversification in your drawdown portfolio, a commercial property fund could do the trick. Investment trusts are usually the best way to get exposure but unfortunately most are trading on massive premiums to their underlying net asset values - meaning they are expensive to buy. This is mainly because low interest rates mean so many investors are on the hunt for high income - and they've all had the same idea. But Henderson UK Property (GB00B7N2XS00) - an open ended fund - is also a good bet. Around two thirds of the portfolio is invested in physical UK property, while the rest is allocated to securities. It is currently offering a 4.2 per cent yield and has a TER of 1.2 per cent. And Mr Baxter warns against plumping for small commercial property funds - as they could take years to sell, which would be a disaster if your circumstances changed and you wanted to quickly get out of drawdown and buy an annuity.

Read more on commercial property funds

Absolute return

Designed to remain strong and steady - even in a bear market - these funds could be good to preserve capital and protect you from downside risk. On average absolute return funds are delivering yields of about 4 per cent, but there an increasing selection of funds delivering above this level. We like Newton Real Return (ISIN: GB0001642635), which is one of the few absolute-return funds that has delivered on its goals. It delivered positive returns even during the financial crisis in 2008. It invests predominantly in a portfolio of UK and international securities. But it may also invest in deposits, money market instruments, derivative instruments, forward transactions and collective investment schemes.

See which other absolute return funds are reliable

Performance of recommended funds

Source: Morningstar as at 28 January 2014.