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Diversify to get the retirement income you want

Our reader wants to supplement his workplace pension. His first step will be to deal with crossover issues
February 11, 2016, Patrick Connolly & Angela Murfitt

Richard Barton is 69 and has been investing since 1998. His primary aim is to boost his Southern Electric pension.

Reader Portfolio
Richard Barton 69
Description

Funds in Isa and shares

Objectives

Boost workplace pension

"A 4 per cent yield would be superb, but it seems that this is difficult," he says. "My wife and I are both retired. I worked for Southern Electric most of my working life, as electrician, foreman and latterly as an engineer in charge of three depots. The last 14 years of my working life I taught offshore sailing to Yachtmaster level. My wife worked as a bank manager.

"We have reasonably substantial cash savings, but these are not earning the income they should any more than the investments.

"I am not good at taking risks, and in SSE (SSE) and National Grid (NG.) I have a couple of pretty safe bets.

"My last trade was reinvesting in National Grid scrip dividends, and our last individual savings account (Isa) investments were both put into CF Woodford Equity Income Fund* (GB00BLRZQ620).

"I intend to invest our 2016 Isa allowances into one of our existing funds."

 

Richard Barton's portfolio

HoldingNumber of shares/unitsValue (£)% of portfolio
Artemis Income (GB00B2PLJJ36)20,175.3243,637.716.79
Newton UK Income (GB00B7W2G379)68,530.6241,789.9716.08
Invesco Perpetual High Income (GB00BJ04HQ93)1,337.0723,259.88.95
Rathbone Income (GB00BHCQNL68)7,706.9763,842.9824.57
CF Woodford Equity Income (GB00BLRZQ620)33,065.1738,150.5814.68
SSE (SSE)2,69539,832.115.33
National Grid (NG.)9979,372.83.61
Total259,885.93

Source: Investors Chronicle

 

THE BIG PICTURE

Chris Dillow, Investors Chronicle's economist, says:

Ordinarily, I would advise readers against looking for high yields. What matters isn't income, but total returns: if a stock rises you can create your own dividends simply by selling some of it - often on more favourable tax terms. A high yield can sometimes be a sign of high risk and impending disaster: think of miners 18 months ago, or housebuilders and mortgage lenders in 2008.

Whether by accident or design, however, you have found the right way to buy high-yielders in that you've opted for defensive stocks. This is a good thing because we have strong evidence from around the world that less risky stocks, on average over the long run, tend to do better than they should. This is partly because investors overlook them in the - often futile - pursuit of big short-term profits. It is also partly because fund managers who are judged by relative returns steer clear of them for fear that they might underperform a strongly rising market.

It's not just your direct holdings that are defensive, your funds are too. They have substantial exposure to defensive stocks such as Imperial Tobacco (IMT), AstraZeneca (AZN) and GlaxoSmithKline (GSK). In this sense, you're doing the right thing. But I have a few words of caution.

Defensive stocks are only relatively defensive. They still have a highish chance of losing money. For example, National Grid's volatility since 2000 implies that it has around a one-in-six chance of losing 12 per cent or more over a 12-month period. This is better than most other shares, but is still significant. In fact, past volatility might understate the dangers facing utility stocks, as these face political risk: a future government might impose tough price controls or even nationalise them.

 

Patrick Connolly, certified financial planner at Chase de Vere, says:

You face a very common dilemma in trying to generate a reasonable level of income from your investment portfolio. It seems that the days when people could generate a decent return from their cash savings are gone. In many cases this has persuaded savers to increase the amount of risk they're taking.

Although cash is generating very little the outlook for other asset classes isn't entirely rosy either. The yields on many fixed-interest investments are unattractive, largely due to the actions of central banks and the demand from investors for perceived safety and security.

The yields on equities look appealing, but this doesn't tell the whole story. In many cases this is because share prices have fallen. To add to the concerns of equity income investors, some companies have already cut their dividend payments and more will follow, especially in sectors such as mining or oil.

You need to make sensible investment decisions. It is better to have the right asset allocation generating a lower level of income than the wrong asset allocation producing a higher income - especially if the latter scenario involves taking more risks.

 

Angela Murfitt, chartered financial planner at Fairstone Financial Management, says:

Your aim for a 4 per cent yield is quite ambitious, especially since you say you are not good at taking risks. Risks are relative to the individual and their circumstances, and as most of your portfolio is held in the equity income sector, you may find that you are taking higher risks with that part of your portfolio than you realise.

You have experienced yields from your investments below expectations and this could be because the yields advertised by fund providers are based on historical performance - future performance is not guaranteed. Dividend payouts are affected by the bigger economic picture and have been under pressure lately, also a reason why you may not have seen the yield you expected.

Another factor could be how ongoing charges are applied to your investment. These often are applied to capital, which erodes the base from which income is derived and is self-perpetuating - less capital means less income.

Your portfolio lacks diversification because it is either in cash or entirely in the equity income sector. This approach is rather black and white with a significant part of your capital lazy and underperforming, with the balance loaded towards the UK equity market at the expense of other valid asset classes and geographies.

As you seek yield your existing investments are predominately large-cap shares. You have several fund providers, but this only provides diversification of investment manager and you are relying on their tactical skill for a return over and above the market.

Some of your funds have negative alpha, which means this has not delivered for you. The danger is that the costs outweigh the benefits. The funds you hold typically have significant stock overlap, meaning you are fundamentally exposed to many of the same shares across the funds you hold. This is unsurprising, as the managers operating in the same sector are all seeking similar things and picking from a limited landscape.

Restricting your investment approach in this way means that your portfolio is not efficient: you are potentially not receiving the best return for the appetite for risk that you have.

 

HOW TO IMPROVE YOUR PORTFOLIO

Chris Dillow says:

Your funds are correlated with each other: if one does badly so will the others. This is often the case with funds: any two baskets of stocks will tend to move together simply because they are correlated with the general market. In your case this problem is greatly magnified by the fact that these funds tend to hold similar stocks. CF Woodford Equity Income's top three holdings are Imperial Tobacco, AstraZeneca and GlaxoSmithKline - the same top three that Artemis Income (GB00B2PLJJ36) holds. Rathbone Income (GB00BHCQNL68), Newton UK Income Fund (GB00B7W2G379) and Invesco Perpetual High Income (GB00BJ04HQ93) also have big investments in AstraZeneca. I don't think they are to be blamed for this: there are only a limited number of big stocks paying big dividends. But it does mean you're not spreading risk as much as you might think.

At this stage, many might expect me to warn you against funds charging high fees. But I think you can be excused here. Fees are probably justified if they give you access to segments of the market you can't easily obtain otherwise. This might be the case with defensives. Although there are low-cost exchange-traded funds ( ETFs) that invest in defensives - such as Ossiam FTSE 100 Minimum Variance UCITS (UKMV) - you might prefer the familiarity and track record of longer-established funds. Just be aware that you are paying for this.

Also, remember that there is a downside to defensives. If the market does rise strongly they might well lag behind. But don't be downheartened by this - it's the price you pay for good long-run performance.

 

Patrick Connolly says:

You say you aren't good at taking risks, but hold individual shares - SSE and National Grid - which you describe as pretty safe bets. While you might be correct, it wasn't so long ago that most investors thought the high-street banks were also pretty safe bets. It should also be noted that SSE's share price have fallen from 1,696p in May 2015 to around 1,400p at the time of writing. Subject to managing any capital gains tax liabilities, I would suggest selling the individual shares.

The investment funds that you hold are all decent quality, but they are all UK equity income funds, which means there will be a high crossover of underlying stocks. As capital protection is probably an important consideration for you, I would suggest diversifying this portfolio geographically and by asset class.

You could sell your individual shares and perhaps Newton UK Income Fund and reinvest the proceeds into global equity income funds such as Artemis Global Income* (GB00B5N99561), which yields around 4 per cent, and Threadneedle Global Equity Income (GB00B7S8N055), which yields around 3.8 per cent.

You could also reinvest into other asset classes through funds such as Henderson Strategic Bond* (GB0007502080), which yields 5.1 per cent, Rathbone Ethical Bond (GB00B7FQJT36), which yields 4.7 per cent, and M&G Property Portfolio* (GB00B89X8P64), which yields 3.5 per cent.

If the portfolio doesn't deliver the level of income you want you could settle for a lower level of income, take capital withdrawals from your investments or invest some of your existing cash savings to generate a better yield.

 

Angela Murfitt says:

I would advocate a much more diversified approach, including some limited exposure to overseas markets, bonds and importantly direct commercial property.

You could consider accessing funds in the Mixed Investment sectors which limit exposure to equities but open up the opportunities of other geographies and other asset classes. Premier Multi Asset Monthly Income Fund (GB00B7GGPC79) has been delivering a historic yield of 4.53 per cent with impressive capital growth. All this is achieved in a lower-risk manner from a hybrid investment approach, which your current strategy misses out on.

I realise bond markets are out of favour at this point in the cycle, with a rise in interest rates looming and talk of a bond bubble. However, some short-duration exposure can bring that all important diversification to this portfolio, providing some yield without significant worry about the effects of a rate change on capital value. You could consider Smith & Williamson Short Dated Corporate Bond (IE00B43RH379) which is quoting a historic yield of 3.95 per cent and is significantly lower risk than the funds you are currently using.

Exposure to direct commercial property will also bring a valuable level of yield, together with long-term growth potential. I like the Threadneedle UK Property Fund (GB00B23FNT51), which has a great track record and offers a respectable yield. You need to be mindful of liquidity risk with property as commercial property is not as tradeable as shares. However, as long as your exposure is sensible, that should not present too big a risk in a properly constructed portfolio.

Diversifying in this way is likely to bring down the overall risk of the portfolio and provide a more predictable level of income with which you can work. As with all investment planning, regular reviews are extremely important as markets move quickly and you need to be able to act and rebalance accordingly.

*IC Top 100 Fund