David is 76 and has been investing for 40 years. He and his wife have £875,000 invested in direct shares and funds, mostly held tax-efficiently in self-invested personal pensions (Sipp) and individual savings accounts (Isas).
To maintain their lifestyle, they need to generate £60,000 in annual income, partly made up of state pension income (David £14,205 and wife £4,604) with the rest drawn from the investment portfolio.
David says: "We own our £1.5 million property outright. We also have £90,000 in cash, premium bonds and building society accounts. In the next 12 months we expect to inherit £300,000.
"In May 2014 we gifted £300,000 to one of our two sons. We enjoy living in our house but realise we will have to downsize at sometime. Our sons are 47 and 43. Neither are poor but they will appreciate an inheritance one day."
David describes his attitude to risk as "medium" but says he "likes to take an occasional punt".
Sipp and Isa
DAVID AND WIFE'S PORTFOLIO
|DAVID'S SIPP INCOME DRAWDOWN|
|CF Woodford Equity Income Z Inc||£30,102||3.5|
|Invesco Perpetual Enhanced Income (IPE)||£24,735||3|
|Jupiter Strategic Bond I Inc||£19,268||2|
|National Grid (NG.)||£34,028||4|
|Newton Global Income W Inc||£21,077||2.5|
|Phoenix Group Holdings (PHNX)||£16,650||2|
|Premier Optimum Income C Inc||£19,963||2|
|Real Estate Credit Investments (RECI)||£10,500||1|
|Royal Dutch Shell (RDSB)||£18,430||2|
|Royal London Sterling Extra Yield Bond Y Inc||£146,247||17|
|Schroder Income Maximiser Z Inc||£18,879||2|
|Vodafone Group (VOD)||£38,682||4|
|DAVID'S STOCKS AND SHARES ISA|
|Ecclesiastical Insurance Office 8.625% Non-Cumulative Itrredeemable Pref (ELLA)||£12,500||1.5|
|European Assets Trust (EAT)||£4,641||0.5|
|HL Multi-Manager Income & Growth Trust A Inc||£21,175||2.5|
|Invesco Perpetual Enhanced Income (IPE)||£23,862||3|
|National Grid (NG.)||£10,633||1|
|Newton Global Income W Inc||£4,777||0.5|
|Phoenix Group Holdings (PHNX)||£8,325||1|
|Royal London Sterling Extra Yield Bond Y Inc||£5,849||1|
|Schroder Income Maximiser Z Inc||£4,675||0.5|
|Vodafone Group (VOD)||£9,626||1|
|WIFE'S STOCKS AND SHARES ISA|
|BAE Systems (BA.)||£17,893||2|
|Coventry Building Society 6.092% PIBS||£50||0|
|Ecclesiastical Insurance Office 8.625% Non-Cumulative Irredeemable Pref (ELLA)||£17,500||2|
|European Assets Trust (EAT)||£6,851||1|
|Investo Perpetual Enhanced Income (IPE)||£7,275||1|
|Kames High-Yield Bond B Acc||£7,210||1|
|National Grid (NG.)||£10,633||1|
|Northern Electric 8,061p Net Cum Pref (NTEA)||£5,680||1|
|Phoenix Group Holdings (PHNX)||£8,741||1|
|Schroder Income Maximiser Z Inc||£12,437||1.5|
|St Modwen Properties 6.25% Bonds 2019||£14,310||2|
|Vodafone Group (VOD)||£11,986||1.5|
|WIFE’S SHARE ACCOUNT|
|John Laing Group (JLG)||£10,059||1|
|Tate & Lyle (TATE)||£29,406||3|
Source: Investors Chronicle
LAST THREE TRADES
National Grid (buy), Tate and Lyle (buy), Real Estate Credit Instruments (buy).
European Assets Trust, Rathbone Income Fund.
THE BIG PICTURE
Chris Dillow, the Investors Chronicle's economist, says:
Why do some stocks have higher yields than others? This apparently abstruse question holds the key to whether your investment strategy is right or not.
You say you want an income of just over £40,000 a year from this portfolio, which is equivalent to a yield of 4.7 per cent. You can achieve this from higher-yielding stocks such as GlaxoSmithKline (GSK), National Grid (NG.) or Royal Dutch Shell (RDSB) and from funds that invest in such stocks.
But this raises my question: why are these on high yields? One possibility is that it is because investors believe such shares offer low future growth, in which case a high yield is merely compensation for a lack of capital appreciation.
If this is the case, though, you might as well simply hold equities generally - say through a a FTSE All-share index tracker fund - and create your own income by selling some shares from time to time. This might actually be more tax-efficient, as it allows you to take advantage of your £11,100 capital gains tax allowance (CGT). Yes, doing this means you are creating an income by sacrificing future capital. But you are doing exactly the same if you hold high-yielding, low growth shares.
Why, then, prefer the latter strategy? There's a bad reason and a good one.
The bad reason is that you’ll feel guilty selling shares because you are reducing your sons' inheritance. Such a feeling would be misplaced: you are also cutting their inheritance if you forego growth opportunities by investing in lower-growth stocks.
There is, though, a better reason for preferring such shares. It's that their yields don't just reflect a rational belief that such stocks offer low growth. It could be instead that large defensive stocks such as National Grid or Glaxo are under-priced. Investors fail to see that corporate growth is largely random and so overpay for stocks that appear to offer growth. The obverse of this is that duller stocks get under-priced and so offer higher returns. History tells us that defensive stocks tend, on average over the long run, to do well.
Your portfolio is, in effect, a bet on this continuing. The debate between those who think the stock market is efficient and those who think that some stocks are systematically mispriced might sound like an abstract academic question. But it's not. It holds the key to whether you should hold income stocks or create your own income by simply selling the general market.
However, you are not just holding stocks but also corporate bonds. There's a risk here. Their higher yields reflect credit risk - the danger that prices of such bonds will fall if investors' become less confident about the companies' creditworthiness. This risk would increase if or when the economy slows down or enters recession. Are you justified in taking this risk?
I suspect you might be. For one thing, you are retired. This means that you are not exposed to recession risk in the labour market, which means you are better placed than most of us to take on the risk. And for another thing, the fact that you are prepared to move to a smaller house means that you could regard your housing wealth as a cushion; if you do lose on your bond holdings, you could top up your wealth by selling your house. Note, though, that it would fall in price in the event of recession, and would take some time to sell, so you should not regard this as an excuse to take on more risk.
My point here is that your strategy is based upon a couple of implicit assumptions – on defensive stocks being under-priced and recession risk being tolerable. I suspect these assumptions are justified. But please give them some thought.
IMPROVING YOUR ASSET ALLOCATION
Paul Taylor, chartered financial planner at McCarthy Taylor, says:
The portfolio is overweight in equities and high-yield bonds. We suggest adding property and infrastructure, while achieving a greater spread of exposure to income producing equities by moving from directly held shares to a collective approach.
High-yield bonds and some individual stocks are going to be vulnerable to interest rate rises, which we expect next year in the UK and earlier in the US. By moving out of these now gains can be retained and rolled over to diversify the portfolio.
These changes should not give arise to CGT as the portfolio is mostly held in tax shelters. Recent budget changes means reviewing where you are taking your income from, as the Sipp can be passed on inheritance tax (IHT) free, not usually the case for Isas unless invested in Alternative Investment Market (Aim) stocks that benefit from business property relief. The ability to leave £1m IHT free in your home opens the question of downsizing to that extent and releasing capital to generate income outside of the Sipp.
David and wife's portfolio: asset allocation analysis
|Asset class||McCarthy Taylor balanced strategy %||Current portfolio allocation %|
Data source: McCarthy Taylor, using FE Analytics
Amanda Tovey, investment manager and head of direct equity at Whitechurch Securities, says:
The asset allocation of all the portfolios combined wth your additional £90,000 cash meets the medium risk criteria with around 34 per cent in bonds, 39 per cent in UK equities, 4 per cent in global equities and 22 per cent in cash. Looking at the individual accounts, however, some of them are entirely equity with a little cash making them much higher risk and you need to consider if you are comfortable with this allocation.
The equity portion of the portfolio is heavily skewed towards the UK with very little international exposure. While traditionally UK equities were favoured over international equities for income, there are now a number of excellent income generating overseas funds which would provide a greater level of diversification to the portfolio.
Paul Taylor says:
The iShares UK Dividend UCITS ETF (IUKD) uses physical replication of the index which offers exposure to the 50 highest yielding UK stocks within the FTSE 350 Index, excluding investment trusts. This exchange traded fund (ETF) currently pays 4.43 per cent a year paid quarterly and its charges are 0.40 per cent a year.
A property fund to be considered is the Tritax Big Box Reit (BBOX). This is the first listed vehicle to give exposure to 'Big Box' assets in the UK; modern, very large, highly efficient distribution centres and logistics hubs that focus on lowering the costs of delivering products. The trust's tenants are quality names such as Marks & Spencer, Next and Rolls-Royce, with strong covenants and opportunity to enhance capital value or income through active asset management: The yield is currently 5.66 per cent, paid half yearly.
For infrastructure consider International Public Partnerships (INPP). The portfolio consists of high quality infrastructure projects with government-backed revenues, providing strong contractual certainty of future cash flows. These are geographically diversified investments across seven countries in a variety of sectors focused on yielding investments with some prospects for future capital appreciation. The yield is 4.54 per cent paid half yearly and the cost is 1.2 per cent a year.
Ben Willis, head of research at Whitechurch Securities, says:
I cannot fault your collective investment choices. The combination of yielding investment funds you have selected already cover over a third of your annual income requirement. Though not all the funds you have selected would be my favoured choices, they all have either a strong track record or perform a required function.
For example, Schroder Income Maximiser Z Inc (GB00B52QVQ30) draws criticism by some but it has successfully targeted an annual income of 7 per cent since launch, using covered calls at the expense of potential capital upside. It provides an extremely high relative yield in the current low rate environment, fulfilling a key objective.
My only mild concern is the amount invested in Royal London Sterling Extra Yield Bond Y Inc (IE00BJBQC361). You may want to consider spreading your bond exposure across more funds. However, it's not a significant issue as the Royal London fund is another excellent fund choice compared to its peer group.
Amanda Tovey says:
Looking at the structure of the UK allocation there will no doubt be a significant amount of overlap between individual shares held and those held on some of the funds. It would be beneficial to look at the structure of this section of the portfolio and reassess what its objective is (we assume income) and what each investment is contributing.
For example there is a significant amount of stock specific risk within the portfolio with nearly 7 per cent of the total portfolio in both Vodafone (VOD) and GlaxoSmithKline (GSK) and 6 per cent in National Grid (NG.) yet Aviva (AV.) and Northern Electric (NTEA) constitute 0.21 per cent and 0.61 per cent respectively and are therefore making little overall contribution.If income is the primary function John Laing Group (JLG) is not currently providing a yield.
Reducing some of the larger weighted stocks in favour of those which you have conviction in but currently have a smaller allocation too would reduce some of this stock specific risk.
*None of the above should be regarded as advice. It is general information based on a snapshot of the reader's circumstances.