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Can this 66-year-old retire on a high natural yield?

Our reader wants to draw the natural yield from his Sipp as a pension
March 17, 2016, Andrew Miles and Scott Bradshaw

Our reader is 66 and has been investing for seven years. He holds all his funds within a self-invested personal pension (Sipp) worth £1,623,000. He hopes to generate a return of 6-7 per cent a year and to draw the natural yield from his Sipp annually as a pension. This is currently £80,000 a year.

Reader Portfolio
Anonymous 66
Description

Self invested personal pension (Sipp)

Objectives

Return of 6-7 per cent a year

His returns in the past five years have been as follows: 8 per cent in 2015; 9 per cent in 2014; 17 per cent in 2013; 16 per cent in 2012; and nil in 2011.

"My wife and I intend to leave my Sipp to our three daughters and eight grandchildren," he says. "Our current plan is only to draw the natural yield out of my Sipp and leave the capital sum to the family. The income for 2016 is projected to be £80,000, based on current yields. We recognise that the value of the fund might devalue in real terms if I do not achieve a 6-7 per cent return.

"I also have a state pension of £7,000 a year and non-executive director earnings of £12,000 a year. My wife has pensions of £14,000 a year gross.

"In addition to our main property we have a second home worth £600,000, which is not rented out, and cash individual savings accounts (Isas) and bonds worth £70,000. I also have a 50 per cent share of a trust fund worth £70,000. This passes to me on the death of my stepmother.

"I am looking for a reasonable return and am prepared to accept a reasonable level of risk. If there was another financial crash and equities went down 50 per cent, this would reduce the fund by £300,000, I could live with my portfolio declining by that amount.

"I mainly, but not exclusively, put my money into investment trusts. I follow Investors Chronicle commentator John Baron's monthly column for ideas and have read his book, Financial Times Guide to Investment Trusts: Unlocking the City's Best Kept Secret.

"I aim to have an actively managed portfolio with a yield of at least 5 per cent and I am nearly always fully invested. I am prepared to change the asset allocation if I consider the outlook for certain assets has changed. For example, as part of my recent annual review, I switched £90,000 from bond funds into alternative energy investment trusts. The outlook for bonds in coming years appears to have deteriorated as interest rates may rise, and alternative energy investment trusts offer inflation-linked income and have looked better value in recent months. I am reluctant to buy investment trusts at a premium to net asset value (NAV).

"I recently split the equity part of the portfolio into two groups: growth and income. In the past few months I invested in Murray International (MYI)*, given its attractive yield of 5.7 per cent and relatively small premium to NAV of 2 per cent when I invested.

"I have been overweight commercial property funds for a number of years. I recognise that returns have peaked, but I still think it is a good source of income and has potential for limited capital growth over the next 18 months.

"My last three trades were the sale of RIT Capital Partners (RCP)* and Invesco Perpetual Enhanced Income (IPE); and the purchase of JPMorgan European Investment Trust - Income (JETI).

"I review future opportunities by looking at recommendations in Investors Chronicle and other publications.

 

Our reader's portfolio

HoldingNo of units/sharesValue (£)% of portfolio
City Natural Resources High Yield Trust (CYN)28,30022,0001.36
BlackRock Commodities Income IT (BRCI)34,46918,0001.11
Fidelity Enhanced Income W (GB00B87HPZ94)47,10150,0003.08
European Assets Trust (EAT)7,61182,0005.05
Henderson Far East Income (HFEL)22,48660,0003.7
Murray International (MYI)4,76037,0002.28
JPMorgan Global Emerging Markets Income Trust (JEMI)95,12323,0001.42
JPMorgan European Investment Trust - Income (JETI)23,07030,0001.85
CF Woodford Equity Income Fund (GB00BLRZQB71)33,64741,0002.53
Perpetual Income & Growth (PLI)11,07145,0002.77
Finsbury Growth & Income (FGT)7,90244,0002.71
RIT Capital Partners (RCP)4,16548,0002.96
Fundsmith Equity (GB00B41YBW71)36,02876,0004.68
Scottish Mortgage Investment Trust (SMT)13,97036,0002.22
Independent Investment Trust (IIT)7,66631,0001.91
Picton Property Income (PCTN)71,00155,0003.39
Standard Life Investment Property Income Trust (SLI)103,79086,0005.3
F&C UK Real Estate Investments (FCRE)53,94460,0003.7
Ediston Property Investment Company (EPIC)27,43849,0003.02
GCP Student Living (DIGS)32,43845,0002.77
Empiric Student Property (ESP)66,38975,0004.62
Tritax Big Box REIT (BBOX)na67,0004.13
Bluefield Solar Income Fund (BSIF)30,02231,0001.91
Greencoat UK Wind (UKW)27,49330,0001.85
John Laing Environment Assets (JLEN)29,32230,0001.85
GCP Infrastructure Investments (GCP)34,33341,0002.53
City Merchants High Yield (CHY)16,557300001.85
CQS New City High Yield Fund (NCYF)148,030820005.05
Henderson Diversified Income (HDIV)35,128340002.09
Tideway Global Navigator (LU0639321677)441330002.03
Starwood European Real Estate Finance (SWEF)48,480520003.2
Barclays Bank 7.125%37,000410002.53
Ecclesiastical Ins Off 8.825% non cum pref J&D40,08354,0003.33
Aviva 8.75% CUM Preference Share35,71350,0003.08
Cash 35,0002.16
Total1,623,000

 

THE BIG PICTURE

Chris Dillow, Investors Chronicle's economist, says:

This portfolio seems well-diversified and I like your reluctance to buy investment trusts at a premium. There's decent evidence that discounts that are big relative to their history can sometimes be a buying signal because they can indicate that sentiment is unusually and perhaps irrationally depressed.

However, nominal gross domestic product (GDP) in the west is unlikely to grow by much more than 4 per cent in the next few years. This implies that the cash flows to your assets - dividends, earnings and rental income - are unlikely to grow by 6-7 per cent, unless rents continue to rise relative to national income - a process that would eventually choke off economic growth altogether. This suggests that such returns are likely only if prices rise relative to cash flows.

This could happen, to the extent that sentiment towards equities - especially commodities and emerging markets stocks - is now unusually depressed and so could eventually bounce back. It's also possible that better sentiment would boost alternative energy investment trust prices.

While this could give a big short-term boost to much of your portfolio, I'm not sure that average long-run returns of 6-7 per cent are feasible any more in an era of secular stagnation. This implies that you might well suffer some loss in real terms if you take 5 per cent a year out of it.

However, as you could cope with a loss of £300,000 this prospect may be tolerable.

 

Andrew Miles, head of research at Ascot Lloyd, says:

It makes sense to diversify your investible assets away from a single structure. Recent legislative changes have increased the flexibility and planning opportunities within a Sipp, but also serve as a reminder of the capricious way in which these instruments can be subject to political whim.

So you should strongly consider alternative arrangements such as building up an Isa portfolio. You could also consider structures such as venture capital trusts which will complement your existing portfolio and potentially provide additional tax benefits.

 

Scott Bradshaw, investment manager at Mattioli Woods, says:

I wouldn't suggest any major changes to your portfolio as it is well diversified and not overly reliant on any one area for income, and you evidently have a well thought out, clear long-term strategy. Investment trusts have advantages for longer-term strategies as they can gear (take on debt) and don't have to manage daily fund flows. Your desire to pass the Sipp on to your children and grandchildren, as well as provide an income for you, mirrors the objectives of some of the trusts you use, including RIT Capital Partners, which is 40 per cent owned by the Rothschild family.

 

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

A big market downturn would hit your equity holdings, but it might also hit your non-equity investments too.

CQS New City High Yield Fund (NCYF)* has been highly correlated with many of your equity investments. Taking the last 10 years of annual returns, it has had a correlation of 0.79 with Scottish Mortgage Investment Trust (SMT)* and 0.87 with Murray International. All three, for example, did badly in the 2008-09 financial crisis because recessions don't just hurt share prices, but also increase default risk, causing prices of higher-yielding bonds to fall.

Worse still, the sort of major downturn that causes equities to fall and credit risk to rise would probably also hit the property market, giving you losses on this as well.

This poses a question. You've tweaked your portfolio to prepare for rising interest rates, but have you tweaked it enough? I think the answer is yes, if we see an ordinary pro-cyclical rise in rates. In this event, good quality bonds probably would fall, but the chances are that equities would do well, simply because the same economic growth that lifts interest rates also improves investor sentiment and earnings expectations.

The problem comes if we get a rise in rates that isn't justified by a stronger economy: the stock market's fall after the December rise in US interest rates gave us a hint of the trouble this can cause. And if we get a sterling crisis, say because of the UK's current account deficit and/or the UK leaving the European Union, rates might rise as the economy weakens. That would hurt your property investments and UK equity holdings. So do you really have sufficient overseas investments to protect you from this?

 

Andrew Miles says:

Overall your portfolio is well diversified across asset classes and we would suggest that its composition represents an above-average attitude to risk. This is commensurate with your observations and investment objective of 6-7 per cent a year. However, we would seek to further explore your capacity for loss and the risks presented by all elements of the portfolio - not only the equity allocation.

The exposure to bonds may become problematic, given that interest rates have never been this low and bond supply has never been higher. In the long run, heavily indebted governments require an inflationary outcome to remain solvent, and your investment trusts have a substantial exposure to unsecured bank debt. Bank equity and debt has had a bumpy ride recently, so further diversification may be appropriate.

The exposure to property also looks punchy. Notwithstanding your comfort with this asset class, if you include your second home it represents nearly 50 per cent of your entire assets, and with the inclusion of your family home maybe considerably more. What holds for bonds also holds for property: it is an interest-rate-dependent asset.

You could consider de-risking the portfolio by reducing your exposure to property and fine-tuning the equity fund exposure, and reallocating to more defensive absolute-return-style funds with less equity risk.

 

Scott Bradshaw says:

We agree that commercial property continues to be relatively attractive, particularly as an income play. While investors have seen returns from capital growth over the past few years, we now see income being the key component of returns going forward. You have a good selection of trusts in this space, including some in the more specialist areas such as retail warehousing and student accommodation.

You have been cutting your fixed-interest exposure recently in favour of alternative energy vehicles. Our portfolios have the lowest exposure to bonds they have had in recent years, with concerns over the impact of both potential rate rises and credit quality, particularly in the energy sector.

In terms of the underlying regional exposure of the equity element of the portfolio you have relatively high exposure to European equities, but one area that is scarcely represented is Japanese equities. We like Japanese equities given the structural reform story of Abenomics - the economic policies put in place by Japan's Prime Minister Shinzo Abe. JPMorgan Japanese Investment Trust (JFJ) and Baillie Gifford Japan Trust (BGFD)* are both interesting options in this space, although they may struggle to meet your yield target as Japan is traditionally a low-yielding market.

Another area we favour in our portfolios is smaller companies, an area to which you have some exposure, most notably through European Assets (EAT)* - one of the best performing trusts overall over the past five years - and Independent Investment Trust (IIT). Against the backdrop of lower global growth smaller companies offer better growth potential as they may expand the size of their businesses. After all, it is far easier for a small manufacturer to double sales than it is for a company the size of Shell (RDSB) or HSBC (HSBA).

* IC Top 100 Fund