How can we get an income of £1,350 a month from our Isas?

Andrew and his wife are ages 59 and 56. He receives a former workplace pension of £50,000 per year, linked to Consumer Price Index (CPI) inflation. She earns £8,800 per year from their company, but this will reduce to around £1,800 per year from April 2022 and she will not earn anything from the company from April 2024. The company will make its final contribution to her self-invested personal pension (Sipp) in the 2021/2022 tax year.

Their home is worth £650,000 and is mortgage-free.

“We would like an income from our individual savings accounts (Isas) of £1,350 per month from April 2022, and we would like this income to grow at least at a rate of CPI plus 1 per cent,” says Andrew. “We want to be able to cover costs such as replacing cars and white goods, and house maintenance, as well as partly fund holidays for the rest of our lives.

“We plan to use our capital to fund end-of-life care, if necessary. We will leave what remains of our estate to charity.

“So we will move cash savings worth £80,000 into our Isas over the next two years, and gradually transfer Sipp assets into our Isas in the most tax-efficient way possible from 2022.

"My wife will start to receive a CPI-linked pension of £3,600 per year from 2025. I will receive the state pension in 2028 and my wife will start to receive it in 2032. We both have made over 30 years’ National Insurance contributions, although mine are mainly contracted out.

“It would be an understatement to say that Brexit and Covid-19 have added colour to our 35 years' experience of market rises and falls. Nevertheless, we remain steadfast in our belief that equities are the best investment over the long term and that time in the market, rather than timing of the market, is what counts. Although we would be upset by a fall in the value of our investments of 30 per cent or more in any given year, we would stay invested as our pensions allow us to take greater risk in respect of equity investments.

"But we would be more worried by a 30 per cent reduction in our dividend income. We carefully monitor dividends from our portfolio and, so far, they have held up better than we expected in the face of Covid-19. We understand that income can be created by selling the gains on holdings – as well as from dividends. So we have orientated the investments a little in that direction, and wonder if we should do more of that?

"After our Portfolio Clinic review in the issue of 26 January 2018, we made some changes such as selling income-focused exchange traded funds (ETFs). But change can be hard and we are not sure that we have done enough.

"Most of our equity holdings used to be direct share holdings because I got a lot of enjoyment from selecting them. However, in semi-retirement, investing is no longer a fun hobby but rather the main way we supplement our pensions to maintain our lifestyle. So the risk of direct share holdings is no longer so palatable.

"We have continued to diversify our investments away from the UK and think that future growth – including dividend growth – may be led by Asia. Scottish Mortgage Investment Trust (SMT) has done very well for us, but the harder we look at it the more we fear that its core investments are too frothy. For example, how does Tesla (US:TSLA) justify its market cap?

"We have also tried to achieve more diversification via funds such as Downing Renewables & Infrastructure Trust (DORE), BlackRock World Mining Trust (BRWM) and Bluefield Solar Income Fund (BSIF).

"In the new tax year in April, we will be able to invest up to £65,000 tax efficiently within our Isas and my wife’s Sipp. We are thinking of adding BlackRock Frontiers Investment Trust (BRFI), HICL Infrastructure (HICL), Templeton Emerging Markets Investment Trust (TEM), Smithson Investment Trust (SSON), iShares Edge MSCI World Momentum Factor UCITS ETF (IWFM) and Oakley Capital Investments (OCI)."

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:

This portfolio should easily generate your target level of income. £1,350 per month is equivalent to an annual yield of only 2.3 per cent. On average, over the long run you be able to take that out of your portfolio while seeing modest appreciation. This suggests that your focus should be more upon capital preservation than growth.

But you have two problems.

You are taking on quite a lot of global cyclical risk. Emerging market income funds, plus BlackRock World Mining Trust and European Assets Trust (EAT), would do especially badly if investors were to worry about the pace of the world’s economic growth.

The near-term danger is that the world economy might not prove so strong as to validate the run-up in share prices we’ve seen since the summer. If this is the case cyclicals might fall back. The longer-term danger is that we are certain to have several more recessions during the rest of your investment career over which time such funds could fall a lot.

It is in this context that your big pension income comes into play. For many investors, cyclical risk is nasty because it means that their shareholdings fall in value when their jobs or businesses are doing badly. Because you have a safe income, you don’t have this problem so are better able than others to take the risk. This means you can pick up a premium for taking on a risk that doesn’t so much trouble you, as such funds should do nicely in good times.

Nevertheless, think about how to manage this risk. One of the few lead indicators of recession is the US yield curve: when short-term rates rise above 10-year yields it is often a warning sign of a global downturn. So watch out for this, although currently it is telling us things are okay.

Also pay attention to funds' 10-month or 200-day moving averages. Selling them when their prices fall below this can protect investment portfolios from nasty bear markets.

Your second issue is that valuations are indeed challenging, which isn’t just an issue for Scottish Mortgage Investment Trust. Murray International Trust (MYI) and Monks Investment Trust (MNKS) also have some tech exposure (see below). And there’s a danger of contagion because falls in the prices of frothy stocks could drag down other stocks.

This is a big problem because it can take decades for shares to recover once a bubble bursts. For example, the FTSE 100 index is still below the level it hit in 2000 and it took UK shares over a century to recoup the losses they suffered when the South Sea bubble burst. Time in the market is not sufficient protection from falls caused by excessive valuations.

Again, the 10-month rule provides a partial solution. Selling securities when their prices fall below this gets you out after a bubble has partially deflated, protecting you from further falls – which might be big. But holding onto them when their prices are above this average enables you to ride the upside of the bubble.

This isn’t to say you must check these averages religiously – once a month or so is good enough. But you will have to relax your aversion to market timing. This doesn’t always work, but it can partially protect you from big losses.

Zubin Kazak, FCSI chartered wealth manager at Blackadders Wealth Management, says:

From a financial planning perspective, we would highlight the benefits of undertaking a lifetime cash flow analysis – it can be a useful exercise when seeking to answer the types of questions you raise, such as how to secure a future cash yield from your Isas and ensure that you can meet future big-ticket expenditures – planned or otherwise. And perhaps most importantly, it can guide your approach to providing for elderly care costs and needs in later life.   

We fully subscribe to the view that equities remain the most compelling asset class to preserve and grow the purchasing power of your wealth over the medium and longer term. As such, your existing investment portfolio has much in its favour. It appears to have a current yield of close to 3 per cent, based on data from the Association of Investment Companies website. If this is the case, and assuming that the investments are held entirely within Isas, it should comfortably provide your required income stream of £1,350 per month with the prospect of it growing at a rate ahead of current CPI +1 per cent.

Your investment portfolio is made up almost entirely of investment trusts. We would caution against focusing exclusively on this type of fund despite advantages such as being able to borrow to improve returns or dipping into revenue reserves to support the yield.

There are also plenty of excellent open-ended funds which continue to deliver strong risk adjusted returns. Consider the likes of Fundsmith Equity (GB00B4MR8G82), Liontrust Sustainable Future Global Growth (GB0030030067) or Baillie Gifford Pacific (GB0006063340). Although these have a clear growth bias, their minimal income yields can be compensated for by taking gains from time to time so as to create an income stream.

Your investment portfolio lacks sufficient exposure to the unloved but currently compelling relative valuations to be found within UK equities. We would advocate a typical moderately adventurous investor, which is how we would describe your attitude to risk based on the current portfolio composition, to hold approximately 20 per cent in UK equities. Funds we favour for exposure to UK equities include TB Evenlode Income (GB00BD0B7D55), BMO Responsible UK Income (GB0033144857) and CFP SDL UK Buffetology (GB00BKJ9C676).

Bond exposure should also be brought up from a meagre 2 per cent of the investments to around 15 per cent. This could be spread across both the credit quality and maturity spectrums as well by considering duration risk. The Rathbone Ethical Bond (GB00B7FQJT36), Royal London Corporate Bond (GB00BD3GHR10) and Janus Henderson Strategic Bond (GB0007502080) funds look attractive.

Taking modest profits from holdings which have grown to represent more than 10 per cent of the investments' value is often a simple and sensible risk management strategy. Tesla’s rich valuation [at time of writing] does look stretched but this was recognised back in November 2020 when Scottish Mortgage Investment Trust sold down its Tesla position by 40 per cent. In some regards, therefore, there is no need to sell Scottish Mortgage - especially if you understand that Tesla is simply one of that investment trust's many growth-oriented holdings. So sit tight.