On track for £40,000 at age 60, unless equities crash

PHILIP'S PORTFOLIO

Chris Dillow, Investors Chronicle's economist, says:

What sort of returns can we expect on shares? Given that so much of your wealth is in equities, this question is key to whether you can meet your objective of a £40,000 income in four years' time.

Here's how I think about this. First, let's assume that the All-Share index is fairly priced, so that its dividend yield won't change from its current 3.3 per cent. This implies that share prices should move at the same rate as dividends. Let's also assume that dividends grow in line with real GDP. This implies that the share of profits in GDP doesn't change over the long run, and that the proportion of profits paid out in dividends doesn't change either. And let's assume that real GDP grows by a bit less than 2 per cent a year; this is less than its grown in the past, reflecting the possibility of some secular stagnation, the possibility that the great recession did some damage to long-term growth, and the fact that our biggest trading partner is stagnating.

These assumptions imply a real long-term return of around 5 per cent per year: 3.3 percentage points of dividend yield, plus just under two points of capital appreciation.

You might think your overseas equities might grow faster than this. Not necessarily. Imagine that investors expect (say) emerging markets to offer higher returns than the UK. What would they do? They would sell UK stocks and buy emerging market ones. But this trading would shift returns. From their lower level, the UK would offer higher returns and emerging markets lower returns. Expected returns would thus be equalized. The only thing that would stop investors from doing this would be if they thought emerging markets were riskier than the UK.

This simple thought experiment tells us that other equities should beat 5 per cent only to the extent that they are riskier than the UK, and that - on average! - the extra risk should pay off.

For this reason, I work on the assumption of a 5 per cent real return on equities. To the extent that you have some corporate bond funds in your Sipp, your returns will be a bit less: such bonds, being safer than equities, should return less.

Let's therefore assume a real return of 4 per cent per year. On this basis - and assuming you use your £15,000 Isa allowance in the next three years - your total non-housing wealth should grow to around £930,000.

Now, to get a total net income of just over £40,000 you need a gross income of almost £60,000. £26,000 of this should come from your BT pension and say, conservatively, £2,000 in rent from your investment property. So you need another £32,000. If we assume a 4 per cent total real return, then you need £800,000 to generate this income, assuming you leave your capital intact. This means you could take £130,000 out of your pensions in a lump sum.

With average luck, therefore, you are on course to meet your objectives.

Therein, though, lies the problem - luck. There is, of course, uncertainty around investment returns. There's around a 30 per cent chance that you'll suffer a real loss on your wealth over the next three years - though this is balanced by the fact that there's also around a one-in-six chance of your real wealth rising to over £1.1m.

It's in this context that your decision to go part-time should be taken. Working helps to mitigate equity risk; your labour income helps to cushion your wealth if shares fall. Going part-time reduces this cushion.

Here, your partner also helps. You can think of her income as another diversifier against equity risk. And the rental income on her house (which'll be very nice when the mortgage is paid off) also acts to diversify equity risk.

Looking at the pair of you, then, you have a balanced portfolio which should meet your objectives. Whether this justifies you going part-time soon, however, is a personal choice: how much do you value leisure against the loss of a diversification against equity risk?

Paul Taylor, chartered financial planner and managing director at McCarthy Taylor, says:

Your financial affairs are complex. You have money purchase pensions worth around £560,000 and are planning on taking tax free lump sums of roughly 25 per cent, at age 60. Consequently, 25 per cent of these pensions should be put into cash now, as four years is a short period in investment terms and you need to avoid the risk of losing value, if markets adjust downwards, with no time to make up any shortfall.

Given the recent changes in pension regulation from April 2015, we suggest you use the annual pension allowance to boost funds. Every £1 added will have 25p in tax relief added and if you are a higher rate tax payer, another 25p against your tax code. Given full access to pensions will now be available at your retirement age, this offers a significant advantage. If you invested £10,000 a year for four years, assuming no growth this will add £50,000 of fund value.

Based on current values your lump sum is increased by £12,500 to £157,443. After April 2015 you can withdraw whatever amount you wish from the balance of £472,330, subject to tax.

We live in an age of low interest rates and the only way to achieve 5 per cent returns is to use both natural income and gains, implying a continued investment risk. Low-risk investments may not yield more than 3 per cent over the next decade. However, this target return has been achieved historically and your pensions should produce around £23,616 gross, which added to the BT pension, means you should be able meet your target of £40k plus for pensions.

You should consolidate your pensions at or before retirement. We wonder why you are using a self-invested personal pension when the only investment held in it is a Standard Life managed fund? Platform-based pensions offer drawdown facility, lower costs, access to a wide universe of funds and should be considered.

It has been difficult to assess your asset allocation, because of the use of managed and lifestyle funds. Managed funds lack transparency and have layers of charges, not all of which are disclosed in quoted annual charges.

There are a number of individual shares held in your Isas but for a portfolio of this size we would recommend using index trackers funds and exchange traded funds (ETFs), which have lower charges, to track main markets and fund managers like Neil Woodford and Fidelity, to provide stock picking opportunity. We favour the use of Vanguard and L&G for trackers.

Both the pensions and Isas lack asset allocation clarity and that should be the first priority, while using a single provider could reduce charges. Subject to risk tolerance, we would recommend 60 per cent in equities and 40 per cent in other assets, specifically property, infrastructure and cash to achieve diversification. We are concerned that bonds are due for a correction and there is a risk of loss of value, so we would use a mixture of these other assets and cash until the market corrects.

The UK offers global equity opportunity, without exchange rate risk. Go for FTSE 100 and 350 companies, through tracker funds and ETFs, such as iShares for most of the equity element.

The US is now looking fully priced, but over the long term remains a key market. We largely avoid Europe and composite emerging market funds preferring country-specific funds for China, India and Japan.

Marrying your partner will have tax advantages, as will the use of trusts and gifting assets to children, when no longer required. Marriage must be for the right reasons but your estate will attract around £237,600 in IHT on death and possibly more, depending on how your pensions and life assurances have been dealt with. Any transfer of assets between non-married partners will attract capital gains tax.