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How to invest a £1m pension for income

Turning a large pension pot into income poses very different challenges to investing a smaller pension. So make sure you know the difference
August 8, 2014

Welcome to the fourth part of this Investors Chronicle series, How to Invest Your Pension for Income. The challenges of investing a £1m pension are quite different to those that people with significantly smaller pots face. If you do have a big pension pot, it's important to be aware of what these are.

Unless you gamble your pension money away on the horses, or buy several Lamborghinis, with a pot of this size you shouldn't have to worry about running out of money. But how you invest your pension, and how and when you spend it, will make a big difference to the lifestyle you'll be able to enjoy during your golden years.

The first thing to consider are your financial objectives, and how you will use your pension money to achieve them. For example, do you want to spend more during your early years - perhaps on new cars or holidays? Richard Watkins, a financial planner at Close Brothers, says virtually 100 per cent of his clients with pension pots worth around £1m, choose to take a higher income in the early years. And this is fine, he says, as long as you plan ahead to make your money last in the later years. He said: "Some of my clients are wolfing up around 14 per cent of their pension pot a year for the first 10 years of retirement. This isn't the end of the world, but I try to get them to think more about the later years, when then they might also need a higher income."

The 'natural' yield (the average dividend yield on stocks and shares) on a £1m pension will provide income between £30,000 and £50,000 a year. This is roughly enough to cover the cost of a care home. But as some are much nicer than others, ideally most people would prefer to be in a financial position to be able to choose where they live, and you should bear this in mind when planning how much income you'll take from your pension, and when you'll spend it.

Be smart with your tax allowances

One of the perils of having a big pension is paying too much tax. Pension income is subject to income tax in the same way as your ordinary wages are. This means you can take up to £41,865 a year (in 2014-15) before you'll start paying 40 per cent tax.

One strategy financial planners recommend is taking the full lump sum (£250,000) and drawing down the capital to provide a tax-free income of £50,000 for five years. Meanwhile, they advise investing the rest of the pension (£750,000) in a growth-style strategy, aiming to at least replace the lump sum over the period (with a 25 per cent return over five years).

Invest for growth, not income

Since people with large pension pots are often used to affluent lifestyles, they are more likely to want a higher level of income from their pension pot than people with more modest pensions. For this reason, when deciding how to invest a £1m pension, financial planners often tend to recommend growth strategies, instead of income strategies which tend to be a safer bet for people with smaller amounts to invest.

Mr Watkins says: "Income investment strategies simply don't provide the level of returns wealthy pensioners need to replace their pension income. Therefore, growth strategies, which tend to bring in higher returns, are better suited to people with big pension pots. And, because bad investment years won't threaten to leave them on the breadline, they can afford to take a higher level of risk."

Equities should generate the best inflation-beating returns over the long term, and therefore should be the primary component of a long-term growth portfolio. Mick Gilligan, head of funds research at Killik & Co, recommends having around 45 per cent of your portfolio in UK equity, and a large chunk of around 20 per cent in US equity.

For UK growth exposure we like the Marlborough UK Micro Cap Growth Fund (GB00B02TPH60). Mr Gilligan also recommends the fund as part of a growth portfolio (see table). It aims to provide a total return of capital and income in excess of that achieved by the FTSE SmallCap Index (excluding investment companies) over the medium to long term, investing primarily in UK companies that have a market capitalisation of £250m or less.

And for US exposure, one passively managed fund that appears on both Mr Gilligan's suggested portfolio and the IC's Top 50 ETF list list is the SPDR S&P US Dividend Aristocrats UCITS ETF (USDV). It an exchange traded fund (ETF) based on the S&P High Yield Dividend Aristocrats Index, which is designed to measure the performance of companies within the S&P Composite 1500 that have followed a managed dividends policy of consistently increasing dividends every year for at least 20 years. It is eligible for self-invested personal pensions and has a reasonable total expense ratio of 0.35 per cent.

As well as these core exposures, Mr Gilligan also recommends smaller amounts of exposure to hedge funds, bonds, Japan, emerging markets and cash. He said: "It's crucial for investors to ensure their portfolios are properly diversified. If all your holdings are increasing in value at the same time, then your selection of investments probably isn't properly diversified.

"Another important strategy is ensuring you have a blend of investment styles, for example a mix of value and growth stocks, as well as some exposure to smaller companies."

Example growth portfolio for a £1m pension

Asset class / geographyPreferred allocationFundWeight£1,000,000Estimated yield
Cash2.0%Cash2.0%£20,000 0.0%
Bonds7.5%Royal London Sterling Credit Z Fund Inc4.5%£45,000 5.2%
iShares Corp Bond 1-5 yr (IE15)3.0%£30,000 3.0%
Hedge/ absolute return funds8.0%MW Developed Europe TOPS A GBP (B3V2HM6)3.0%£30,0000.0%
Blue Crest AllBlue Fund (BABS)2.5%£25,0000.0%
BH Global Limited ord NPV GBP (BHGG)2.5%£25,0000.0%
UK equity45%Trojan Inv Funds Trojan O Fund Inc (IE00B6127M75)2.5%£25,0000.1%
Vanguard FTSE UK Equity Index Fund Inc (GB00B59H6H54)15.0%£150,0003.6%
Aberdeen UK Tracker Trust (EUK)5.0%£50,0003.4%
Ardevora UK Equity C Fund GBP Acc (IE00B3WN9227)6.5%£65,0000.0%
Marlborough UK Micro Cap Growth P Fund Acc (GB00B8F8YX59)3.0%£30,0000.0%
Majedie UK Income X Fund Inc (GB00B8BH0R25)6.0%£60,0004.0%
Schroder Income Maximiser Z Fund Inc (GB00B52QVQ30)4.0%£40,0007.4%
PFS Chelverton UK Equity B Fund Inc (GB00B1FD6467)3.0%£30,0004.5%
Europe7.5%IM Argonaut European Enhanced Income R Fund Inc (GB00B734ZP78)4.5%£45,0003.5%
HSBC European Index C Fund Inc (GB00B80QGD89)3.0%£30,0002.1%
US21.5%Findlay Park American USD (IE0002458671)3.0%£30,0000.0%
Vanguard S&P 500 ETF (VUSA)10.0%£100,0001.5%
SPDR US Dividend Aristocrats ETF (UDVD)5.5%£55,0001.9%
Fundsmith Equity I Fund Inc (GB00B4MR8G82)3.0%£30,0001.1%
Asia2.0%First State Asia Pacific Leaders B Fund Inc (GB00B62M4K30)2.0%£20,0000.0%
Japan3.5%CF Morant Wright Japan B Fund Inc (GB0033598060)3.5%£35,0000.0%
Emerging markets3.0%Lazard Emerging Markets I Fund Inc (GB0008469586)3.0%£30,0002.0%
100%100%£1,000,0002.18%

Source: Killik & Co