How can I cover a £12,000 retirement income shortfall?

Chris is 53 and his partner is 46, and they respectively earn £56,000 and £8,000 a year. Their children are 10 and seven years old.

Their home is worth about £400,000 and has a mortgage of £80,000 due to be paid off in 2028. They also own a buy-to-let property that has been valued at £155,000. The mortgage on this costs them £400 a month and is due to be paid off in June, but they have decided to sell this property as they believe that there are some risks relating to house prices.

“I want to retire at 60, or sooner if possible, and for my partner to stop working at the same time,” says Chris. “We estimate that we will need £40,000 a year gross income in retirement, and also want to help our children with education costs or a house purchase by giving them each £50,000. When we die we would also like to pass on some assets to them.

"If I die before my partner, she will receive half of my defined-benefit (DB) pension which, with the other sources of income, should be enough to cover any care fees she may incur and leave some capital to pass on to our children.

"Our company and state pensions will eventually supply most of our income requirement, but there will be a significant funding gap until I start to receive my state pension at age 67, which should initially pay around £7,000 a year.

"My index-linked DB pension should pay £23,000 a year from age 60. I also have some additional voluntary contributions (AVC) linked to my DB pension worth £43,000, invested in a passive fund split equally between UK and global equities. At retirement, I plan to take my AVC as a cash lump sum and put it into my Isa over the following three years.

"I contribute 16 per cent of my salary to a defined-contribution (DC) pension, and the total annual contribution is £17,000. This pension is currently worth about £40,000. But as we will soon no longer be paying £400 a month mortgage payments for our buy-to-let property, we could use the money saved to pay off the mortgage on our home early. And when we have paid that mortgage off we could put the same amount of money we have been spending on the two mortgages – £1,200 – into my DC pension until I retire.

"My partner's workplace pensions in aggregate should pay her around £5,000 a year from age 65.

"Our investments are worth about £180,000 and are equally split between a self-invested personal pension (Sipp) and individual savings account (Isa). I contribute £5,000 each year to the Sipp.

"We have emergency cash savings of approximately £15,000, which we aim to grow to £30,000 over the next seven years.

"When we retire we plan to meet the income shortfall by drawing from our Sipp, Isas and AVC. This should be about £12,000 a year in the first seven years until I receive my state pension, and fall to £5,000 for the next seven years because I will have started to receive my state and workplace pensions. And when I have been retired for 14 years we should have an income surplus of £7,000 a year, which we may save to help cover possible care costs in later life.

"I may run down the assets held within the Isa but leave the capital value of the Sipp intact to provide additional income if necessary. This is assuming that the Sipp and Isa’s combined value increases at 4 per cent a year and has a value of about £270,000 by the time we retire. And we would give £100,000 of this to our children.

"If things don’t go as planned one or both of us could work for longer, or we could reduce the amount of the gift we make to our children. Another option would be to run down the Sipp or DC pension.

"I would say that we have a medium to high-risk investment appetite, as we could tolerate the value of our Sipp and Isa falling by up to 25 per cent – as it did in March last year. I am investing with a time horizon of 30-plus years.

"I monitor my holdings daily so that I don't miss any major movements. I trade once or twice a month to buy at a price and level of momentum I’m happy with, and reinvest any dividends we receive. But I will hold most of my investments for years rather than months.

"I try to invest along the lines of themes in assets that I think have a solid long-term future. I have exposure to unquoted companies, renewables, infrastructure, Asia including Japan, healthcare, technology and defensives.

"I would like to add exposure to biotech – in particular genetics, robotics, electric and alternative fuel vehicles, sustainable investments, frontier markets, Europe, Japan and foreign currency. 

"I also want to increase our US exposure but think that this market, especially the tech stocks, is out of touch with reality and due a rerating. So is there a way to invest in the S&P 500 index without exposure to big tech companies?"

NONE OF THE COMMENTARY BELOW SHOULD BE REGARDED AS ADVICE. IT IS GENERAL INFORMATION BASED ON A SNAPSHOT OF THESE INVESTORS' CIRCUMSTANCES.

Chris Dillow, Investors Chronicle's economist, says:

I’m not sure that you will be able to cover the shortfall in your target income when you retire. To get £12,000 a year from your investments you would need equity holdings of around £300,000, assuming that you could draw down 4 per cent a year without losing capital. But seven years of contributions worth £5,000 and moderate growth will leave you slightly short of this.

However, you have margins of adjustment. You could work slightly longer; draw down more than 4 per cent and see your investments' value gradually dwindle, or see if you could manage on less than £40,000 a year. But even then you might have to abandon plans to give your children £100,000 unless you get lucky with equity returns.

A big question is to what extent do you want your children to share investment risk with you? If you’re willing to reduce the amount of your planned gifts and bequests to them you have much more chance of meeting your other objectives.

My caution here is partly because I don't think that the outlook for equities is great. The FTSE All-Share index's dividend yield, which has historically been a great predictor of longer-term returns, is only around average. And at least one good lead indicator of annual returns – the global price-money ratio – is sending a bearish message.

I share your downbeat view of the housing market. I don't think that there will be a collapse, but the outlook isn’t great, unless the government tries to support the housing market by, for example, extending the stamp duty holiday. Equally, though, don't assume that equities will do very well. If you can get a good price for your buy-to-let property grab it, but don’t panic if you don’t.

I am in two minds about your interest in biotech and alternative fuels. These are attractive as they might be the bubbles of the future. But serious investors in this sector need to consider accessing them via private equity and venture capital funds because the best growth might come from companies that are not yet listed. These kinds of funds tend to be illiquid, meaning that they are not suitable for playing bubbles because to do this you will need to sell near the peak, for example, when prices have dipped below their 10-month average after a great run.

So there is a trade-off between being a serious long-run investor in these sectors and just wanting to play a potential bubble.

You can invest in US stocks without having exposure to big tech. There are exchange traded funds (ETFs) that track the S&P 500 but exclude tech, such as ProShares S&P 500 Ex-Technology ETF (US:SPXT), though this is listed in the US. Or there are ones which track an equal-weighted basket of S&P 500 stocks such as Xtrackers S&P 500 Equal Weight UCITS ETF (XDWE). Whether you should invest in them is doubtful, though. The prospects for US companies outside the tech sector aren’t great – profit rates have been trending down for years.

I’d urge you not to look at share prices every day except perhaps to check that they’ve not fallen through a stop-loss limit [if you have any of those in place]. Day-to-day moves are largely noise rather than signal and tell us very little about future trends.

Luke Edmond, consultant at Mattioli Woods, says:

Due to your asset base you have many options for covering your retirement income shortfall of £12,000 per year between ages 60 and 67.

While you should be able to help your children financially to meet education and house purchase costs, I would stress the importance of ensuring your own and your partner’s financial independence. You should achieve this, ideally, by owning your principal residence outright and generating enough income to cover your expenditure while taking on limited investment risk.

Pensions remain a highly tax-efficient structure in which to invest, given the tax relief allowable from making contributions, tax-free growth, opportunity to withdraw 25 per cent of the fund as a tax-free lump sum and tax advantages upon death. You could use your Isa funds to make additional pension contributions and receive basic-rate income tax relief of 20 per cent on up to £40,000 a year, although give this careful consideration.

Instead of withdrawing your tax-free pensions cash as one lump sum, you could make a number of withdrawals over seven years to cover your £12,000 a year income gap. By further funding your pension you aim to try to increase its value to £320,000 by the time you are age 60. This would provide a tax-free sum of £80,000, which you could take in full or over time.

Although you can access your DC pensions as and when required for income, the assets held within them fall outside your estate for inheritance tax purposes. Your principal residence can also be passed on to future generations [tax-efficiently].

Your investments have a particularly high weighting to UK equities of around 55 per cent. While many of these companies derive earnings globally, they remain susceptible to local factors.

Most of these are direct shareholdings, which carry higher risk and potential for volatility. This means that while they may enhance the potential upside they may equally enhance the possible downside. And given the recovery in UK equities due to the recent Brexit agreement and the beginning of the Covid-19 vaccine roll-out, it may be an opportune time to rebalance the geographical weightings of your portfolio.

As the US represents around 16 per cent of global gross domestic product (GDP) this could be an area to consider. 

However, diversification and active management, and aligning the amount of investment risk you take with your objectives, are key considerations when trying to meet financial objectives in the current volatile environment. So as you move towards retirement it might be sensible to de-risk the portfolio, perhaps by reducing its exposure to private equity and unquoted companies.