How can we generate £9,000 per year from our investments?

Steven and his wife are ages 60 and 58, respectively, and they retired in August 2019. They have index-linked final salary pensions which provide them with a joint net income of £2,300 per month, on top of which they get some income from their savings and investments.

Their home is worth around £350,000 and mortgage free. They also jointly own Steven’s late mother’s house which is occupied by their eldest child and her partner, who pay rent of £1 per month plus costs such as buildings insurance. Steven and his wife plan to sell the property in stages to their two children offsetting the profits against their annual capital gains tax (CGT) allowances.

“We want to generate an income to supplement our former workplace and state pensions,” says Steven. “Until I start receiving the state pension in 2027 I would like the investments to generate around £9,000 per year, ideally without having to withdraw any capital. 

“The funds will also need to cover large expenses such as car purchases, property repairs and travel. We may also need to draw on them to help pay care home fees in later life.

“And we give each of our two children £125 per month to invest in self-invested personal pensions (Sipps), with the aim of eventually supplementing their workplace pensions.

“We have equity investments in various individual savings accounts (Isas) and Sipps, which I manage as one portfolio. A large percentage of our money is held in cash and NS&I bonds. But to generate the income we want, we need to increase the proportion invested in equities so each invest £500 per month into our Isas. 

"Prior to the Covid-19 pandemic I felt that achieving our desired level of income would be relatively straightforward. However, the recent dividend cuts make this more challenging.

"We have not yet withdrawn any money from our Sipps, but wondered if we should withdraw the 25 per cent tax-free portion? My wife, who is a non-taxpayer, could also draw the natural income from her Sipp with no tax implications. 

"We have invested for about 30 years in open-ended funds, investment trusts and direct share holdings. 

"While we were still working we were able to tolerate a fall in the value of our investments of up to 30 per cent in any given year so I remained invested during the financial crisis in 2008. As we are now retired I don’t want the value of our investments to fall more than 10 per cent in any given year. But I should be able to remain invested so that I can reap the rewards that will hopefully follow any declines in the value of our investments, and stayed in the market March and April last year.

"I look to buy and hold investments, and run profits, but some holdings such as Lindsell Train Global Equity (IE00BJSPMJ28) have become disproportionately large. I also do not always cut losses as quickly as I should. For example, last September I sold Lowland Investment Company (LWI) which I had held for several years. During this time its share price had fallen 40 per cent and I did not think that there were any indications that its discount to net asset value would narrow.

"I am now thinking of selling Henderson Far East Income (HFEL) and reinvesting the proceeds in existing holdings or, to minimise costs, exchange traded funds (ETFs)."

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:

About a quarter of this portfolio is in cash or premium bonds. These pay negligible returns as the best savings rates, which are mostly offered by challenger banks, are less than 1 per cent – even for deposits locked up for two years. So this portfolio is unlikely to pay out the £9,000 a year you want – £5,000 a year is more likely.

Near-zero interest rates mean that you have to sacrifice lots of return to have security. So your desire to keep annual falls in the value of your investments under 10 per cent carries a heavy cost.

But such a big cash weighting can be justified. There is a significant risk that equities will fall. Share prices globally are high relative to the world’s money stock, which historically has been a good lead indicator of falling prices. And the FTSE All-Share index's dividend yield is below its long-term average, suggesting that valuations are high. This too has been a great lead indicator of below-par returns.

There is also not much point in shifting into gold or bonds. These would probably do well if equities fall because investors would seek safer assets. But the chance of such good returns comes at the price of gold or bonds doing badly if that downside equity risk doesn’t materialise.

So I don’t see any great urgency to massively reduce your cash holdings as doing this would expose you to significantly greater risk.

However, there are two things you could do to manage risk, and which might allow you to cut your cash allocation and increase exposure to equities.

One is to use momentum effects. You are right to run winners and I’m not sure that this leads to disproportionately large holdings. Lindsell Train Global Equity (IE00BJSPMJ28), for example, only accounts for about 15 per cent of your equity holdings and 1.68 per cent of your total portfolio, which isn’t exceptionally high.

But you must be ruthless in cutting losers and there’s a rule for doing this with a proven track record. Mebane Faber, chief executive officer of Cambria Investments, has advocated selling when prices fall below their 10-month or 200-day moving average. This isn’t 100 per cent foolproof – nothing is. But it does protect portfolios from long bear markets of the sort that really destroy wealth. This rule is especially successful with assets that are more sentiment driven, such as emerging markets, because declining sentiment on these can feed on itself, causing protracted price falls and rises.

Implementing this rule can be tricky in complex portfolios, though – another argument for having tracker funds. You are right to consider ETFs, especially for more mainstream types of equity where tracking errors tend to be lower.

Don't chase income. 2020 reminded us of a long-standing fact: a high yield is often a sign of high risk, often of doing especially badly in a recession. This risk pays off well in an upturn, but we might already have had this payoff as the market may be discounting much of this year’s economic recovery.

You can create your own income by selling holdings. What matters is total return, not income. So maintain a well-diversified equity portfolio.

Rachel Winter, associate investment director at Killik & Co, says:

Your objective of generating income of £9,000 per year sounds realistic and achievable, although you will need to invest a significant proportion of your cash to reach this target. As a rule of thumb, it is a good idea to hold three to six months’ worth of expenditure in cash, plus enough to cover any large planned expenses within the next two to three years. Six months’ worth of expenditure for you looks to be about £18,000 and you currently have more than 10 times this amount in cash. Given current low interest rates, I suggest investing some of this cash to ensure that your savings keep pace with inflation – especially as you have retired relatively early. It also sounds as though you will receive more cash in future from the sale of your second property, which lessens the need to hold a large amount of it.

As you have retired, it would not be sensible to invest all of your portfolio in equities. But you could consider some additional non-equity assets that should generate a better return than cash. Tritax Big Box Reit fits this bill and is a great home for your monthly £500 investments. It focuses on logistics warehouses, a sector of the commercial property market that has thrived during lockdown and should continue to do well now that more people have been introduced to online shopping. LondonMetric Property (LMP) is another option in this space.

Hipgnosis Songs Fund (SONG) is another non-equity option that could add diversification to your portfolio while increasing the yield. It is a relatively new concept, which purchases musical intellectual property rights and collects the associated royalty payments. 

Some of your holdings are very small in comparison to the overall size of the portfolio and I agree with your plan to start adding to some of these. Blackrock World Mining Trust (BRWM) accounts for less than 1 per cent of the overall portfolio and would be a good candidate for a top-up. It has a good yield and the mining sector has historically offered protection against inflation. We also expect it to benefit from an increase in commodity demand as governments around the world invest in infrastructure to boost economic growth in the wake of the pandemic.

Although it would be possible to increase the yield of your portfolio, many of today’s most successful companies, such as Amazon (US:AMZN), do not pay dividends. And focusing purely on yielding investments means having to exclude of some of these great technology businesses. So our preferred approach would be to invest for both income and growth, and take the £9,000 you require each year from a combination of income and capital.