Saving up to be a stay-at-home dad

"We have decided that I will be the one who stays at home because my wife is the higher earner and I have already built a significant defined-benefit pension," explains Jake. "My wife and I have been investing heavily for 15 years with a view to one of us becoming financially independent by surpassing a natural yield target or crossover point. We define our 'crossover point' as a portfolio income greater than or equal to the gross UK median income for full-time employees. This was £28,213 in 2016, according to the Office for National Statistics, and we managed to move past it during the course of last year.

"Our objective is, for at least the next 20 years, that the natural yield grows so that it is always equal to or greater than the UK median gross income for full-time employees. I have done historical modelling over 10 years and found that the UK median income has risen by about 2 per cent a year over the past decade. Our portfolio's natural income has grown by about 4 per cent a year over the same period.

"We want our portfolio capital, which we will no longer grow via new investments, to hold its value in real terms over the next 20 years. All dividends and interest will be spent rather than re-invested.

"I think it is likely that our portfolio will meet its income growth and capital preservation objectives over the next 20 years. Our plan does not rely on me working during this period, but I think I will try to work part-time on a freelance basis at some point, although hopefully not because of an actual need to supplement our family income.

"In 20 years' time when I turn 60 my pension of £25,000 a year, which will be adjusted upwards to match inflation, will become available in full and we will feel more comfortable about starting to draw down some of the remaining value of the portfolio to enable whatever retirement lifestyle we might want.

"My wife will continue to invest up to £40,000 a year of her pre-tax salary into her pension over the next 20 years, and we calculate that her pension will almost certainly be much greater in value than mine by the time she hits normal retirement age.

"The portfolio is positioned for maximum income tax efficiency, and we currently receive the full yield entirely free of income tax.

"I do not plan to be active with the portfolio other than occasionally monitoring progress, rebalancing when necessary, and taking advantage of opportunities to reduce overall risk, preserve current yield and capital, and enhance the income and capital growth prospects.

"Are there any better investments for reducing overall risk and volatility while maintaining the current level of income, or that could significantly grow the income stream without introducing more risk and greatly increasing the chances of eroding capital over the longer term? I have recently invested in the Northern venture capital trusts (VCTs), Unicorn AIM VCT (UAV) and Jupiter Asian Income (GB00BZ2YMT70). And I am thinking of putting money into Trojan Global Income fund (GB00BD82KP33)."

Jake and his wife's portfolio

THE BIG PICTURE

Chris Dillow, Investors Chronicle's economist, says:

You want this portfolio to generate income growth of 2 per cent a year and hold its capital value. Economist Nicholas Kaldor said in 1957 that a stylised fact about the economy is that wages and profits should grow at about the same rate over the long term. If this is the case and assuming no great change in the payout ratio, dividends should grow at the same rate as wages and national income.

This should give you roughly 2 per cent real income growth a year. It also implies that unless there's a massive change in valuations, average yields on a well-diversified portfolio shouldn't change much, giving you a small rise in capital values.

So if Kaldor was right your portfolio should achieve these aims. And for the past 50 years, he has been roughly right. The share of profits in gross domestic product (GDP) now, at just over 20 per cent, is pretty much what it was in 1957.

However, there have been some big variations around this long-run constancy. For example, in the 1970s the profit share fell, as did share prices. You are exposed to the risk of this happening again. If wages grow at the expense of profits, your portfolio would lose value and drop below your crossover point. You face what economists call distribution risk, which over a 20-year time horizon is a significant danger.

One way to insure against this is to change your benchmark, as surely what matters isn't the median wages of other people but your own needs? If these are frugal, you can get by on less than the median income, and if not, you can't.

Another protection might be emerging markets. It's unlikely that distribution risk will materialise everywhere, so investing outside of developed economies might help spread the risk.

Jason Hollands, managing director at Tilney Group, says:

I am concerned that your focus on selecting investments that have high yields has led to a very abnormal asset allocation.

This exposes you to far too much risk and over the long period of time you need these assets to work for you, the income growth potential of this portfolio is limited. We've enjoyed an unusually long multi-year bull market, but that won't go on forever and this portfolio could prove very fragile in tougher times.

Not counting your cash, approximately 20 per cent of your portfolio is invested in highly illiquid, very small unquoted or Alternative Investment Market (Aim) companies via your large allocation to VCTs. And 19 per cent is in higher-risk Asian and emerging market equities, with 9 per cent in high-yield bonds and 6 per cent in peer-to-peer loans, which are unsecured.

Just 20 per cent of the underlying portfolio is in main-market UK equities, usually a core component of an income growth portfolio and still the highest yielding developed equity market. You also have 11 per cent in US equities and 9 per cent in European equities. But you have little exposure to Japan which, while relatively low yielding, has seen some of the strongest dividend growth of any major stock market in recent years and has plenty of headroom for future growth.

Colin Low, managing director of Kingsfleet Wealth, says:

Given your objective of achieving a given level of income each year, you are right to focus on maintaining the income at that level and, perhaps more importantly, maintaining its purchasing power as inflation has an impact over time. I would also suggest that you try to maintain the purchasing value of the capital.

The income yields your investments currently generate look quite high and are probably unsustainable. High levels of yield within a fund or as dividends could be indicative of a value trap - where the underlying investments pay dividends at an unsustainable level due to the share price having fallen significantly. And they can indicate that the long-term prospects of the underlying company are not favourable.

With the FTSE 100 yielding about 3.75 per cent anything significantly in excess of this is at risk of reducing in the near future. So I would suggest trying to bring the portfolio yield down to a more sustainable figure of about 3.5 per cent. In more volatile conditions this should provide you with a sustainable income that is likely to grow over time.

It is good to invest as tax efficiently as possible using wrappers such as Isas and where necessary VCTs. But a number of your VCTs seem to be paying an excessively high yield and I doubt that this portfolio could be sustained with any level of capital growth in the long run.

While in employment, don't overlook the tax efficiency of pensions. Even if you can't access them until your mid 50s you may be able to pay into a money purchase arrangement alongside your defined-benefit scheme, depending on how much of your annual allowance and lifetime allowance you have left.

It would be advisable to add further capital to the portfolio and, based on the income level that you are targeting, I think an investment value of £800,000 to £900,000 per individual is much more likely to deliver a natural yield and capital growth that can maintain its real value.

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

You face the risk of inflation, but fully insuring against this is expensive as index-linked bonds pay negative real returns. Partial insurance, however, might be possible: overseas equities would partly protect you against falls in sterling, and commodities would protect against rises in their prices.

Another danger is a serious economic downturn. This would raise default risk so might be detrimental to peer-to-peer lenders and higher-yielding bonds. It would probably also be detrimental to the smaller companies your VCTs hold, which I suspect you invest in for the wrong reason: the case for VCTs isn't that they carry tax breaks, but that future economic growth will come from outside of stock-market-listed companies. You also have liquidity risk as VCTs are not suitable if you need to raise cash quickly.

In this context, what matters is your wife's job security. If this is high, you can afford to take these risks. If not, consider more liquid assets - whether cash or general equities.

Your focus on natural yield could be another danger as high yields often betoken high risk. The main exceptions to this are larger defensive stocks of the sort held by CF Woodford Equity Income (GB00BLRZQB71) and Perpetual Income and Growth Investment Trust (PLI).

But your hunt for natural yield has skewed much of the rest of your portfolio towards riskier assets. A way to mitigate this risk is to shift into UK and global tracker funds. Remember that you can create your own dividends by selling some of your holdings.

Jason Hollands says:

You need to fundamentally rethink your strategy, starting with a more balanced approach to your asset allocation. You should then select investments with greater potential for income growth rather than those with a current high yield.

While I'm a big fan of VCTs, these represent far too big a proportion of your portfolio, although your selection is overall pretty good. VCT yields can be high and dividends are tax-free, but much of this isn't natural yield but rather the distribution of capital from companies exited by the VCTs. This means these high dividend distributions are at the expense of capital growth. And recent changes to VCT rules are making them refocus on early-phase businesses, meaning future income from VCTs may become more erratic.

It would not be a good idea to trim VCTs that you have held for less than five years because this would jeopardise the tax credits you have received. But you shouldn't add any further VCT exposure.

Your portfolio includes a couple of funds that pursue covered call strategies - Fidelity Global Enhanced Income (GB00BD1NLJ41) and Schroder Income Maximiser (GB00B53FRD82). This involves selling options on certain stocks they hold to boost their immediate income - in effect swapping growth potential for some extra income today. That might be fine for someone needing to maximise income, but potentially acts as a brake on income growth.

I would also question some of the niche investments you hold such as VPC Speciality Lending Investments (VSL) and P2P Global Investments (P2P), which invest in loan books. While these offer high headline yields the total returns on these have not been great and P2P Global's board is reviewing this trust's management arrangements.

So I would consider ditching these two trusts, as well as BlackRock Commodities Income Investment Trust (BRCI) as it has been extremely volatile and the outlook for commodities is deteriorating as China reins in its credit growth.

Also consider removing Lyxor SG Global Quality Income NTR UCITS ETF (SGQL), CQS New City High Yield Fund (NCYF) and Sarasin Global Higher Dividend (GB00B850BN01).