How can I buy a £1m home and grow my family's investments?

Catherine and her husband are ages 44 and 39, and have a joint income of about £180,000 a year. Their children are ages nine and seven. Their home is worth about £480,000 and mortgage free.

“We are likely to leave our current jobs in four to five years at which point we plan to spend around £1m on our “forever” home," says Catherine. "I have a non contributary military pension which should pay me an initial lump sum of £60,000 and about £55,000 per year from the date I leave my job. My husband has one that should pay him a lump sum of £40,000 and then £13,000 per year from the date he leaves his job. This means that we will not be reliant on our investments for income.

“But I would still like to grow my disposable income as my cash individual savings accounts (Isas) are not returning much. We would like an average return of 7 to 8 per cent a year, without having to 'play' with the investments too much. I don’t have the time to do this and we lack the expertise – we have been self managing investments for less than three years. I also want to avoid trading fees and try to make gains over the long term.

"I've recently transferred a private stakeholder pension worth about £60,000, which I started in 2003, into a self-invested personal pension (Sipp). This is invested in three tracker funds following a friend's suggestion. I am concerned because the last year appears to show that actively managed funds have done better, but I am not sure that this will the case over the longer term. I am going to continue to see if I can make sensible longer-term investments via investment trusts and I'm thinking of investing more in tracker funds. I like the idea of leaving it to grow with low fees and don’t want to risk important money upon which I will rely in the future.

"I don’t add money to the Sipp because I largely use up my annual pensions contribution allowance. I am also concerned about breaching the pensions lifetime allowance because six years ago my pots had already reached a value of £725,867.

"My husband contributes £500 per month to an investment Isa which is run by a financial advisory firm. He doesn’t have a private pension or lifetime individual savings account (Lisa) but, as he is 39, should he?

We also have £10,000 invested in Octopus Titan VCT (OTV2) for tax purposes.

"We have a ‘play portfolio,’ which we started with an initial investment of £30,000 that has grown to about £50,000. Last year we added Bango (BGO), Scottish Mortgage Investment Trust (SMT), JPMorgan Emerging Markets Investment Trust (JMG), Greencore (GNC) and International Consolidated Airlines (IAG).

Investment trusts seem like a safer option, but I’m happy to hold some riskier investments because of the safety net our military pensions will provide. I am willing for overall moderate risk and prepared for losses, although would be sad to experience a fall in value of £10,000 or more. 

"We tend not to sell our investments, although luckily they are mainly going in the right direction at the moment. That said, I invested £2,000 in Pfizer (US:PFE) when I heard that it had developed a coronavirus vaccine but it has since performed poorly. So should I let go of Pfizer? I also presume that I will need to trim holdings outside Isas and pensions to avoid building up large capital gains tax (CGT) liabilities.

"We want to pass on wealth tax-efficiently to our children, so pay £100 per month into each of their Sipps. We expect that we will pay the full amount possible into each of them this year. I want them to benefit from compounding and to invest their Sipps in the future."

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:

You’re worried because tracker funds are being beaten by active ones. Don’t be. Active funds’ out performance since Covid-19 struck is quite likely an aberration.

You might imagine that somebody picking stocks at random has a 50:50 chance of beating the market. But this is not the case because market indices are weighted by shares’ market capitalisation. So, for example, Unilever (ULVR), with a market cap of over £105bn, has 75 times the weight of AO World (AO.) which has a market cap of £1.4bn. This means that if one or two huge stocks do badly they will drag down the index and most shares will outperform the market. So this random stock picker could appear to do well.

This is what happened last year. One of Covid-19’s effects was to force banks and oil companies to suspend their dividends, causing their share prices to fall sharply. And some of the biggest companies plummeted. For example, since December 2019 HSBC (HSBA) has fallen almost 30 per cent, and BP (BP.) and Royal Dutch Shell (RDSB) almost 40 per cent. These drops have dragged down the index, causing most stocks to beat it. So an active investor with no skill but average luck has probably beaten the market since then.

But there is no strong reason to suppose that this pattern will continue. The tail wind that pushed active funds ahead of tracker funds might die down. If and when it does, trackers will come good again. So don't regard recent events as a reason to favour active funds – you are right to stick with trackers.

You're also right to invest in venture capital trusts (VCTs), but are doing it for the wrong reason. Their virtue is not the tax breaks as these should, in theory, be reflected in higher prices, hence lower subsequent pre-tax returns. But it is possible that most future growth will come from companies that are not yet listed on the stock market, so investors looking for growth should look to VCTs or private equity investment trusts.

However, these kinds of funds are vulnerable to manager risk because one or two stellar performers or failures can make a big difference to returns. So it might be wise to spread this risk by having a few different VCTs or private equity funds.

I don’t like kick-out plans as they are often opaque and high-charging, and don't do anything you can't do yourself. If you want exposure to the FTSE 100 but with limited downside risk, just hold a tracker fund alongside some cash. Sellers of structured products are taking advantage of a common error investors make: they judge each investment in isolation and fail to remember that what matters is one’s portfolio as a whole.

A big alarm bell for me is that you never sell investments. Other than with tracker funds, you must do this at some point because economic growth is a process of creative destruction – it creates companies while destroying others. If you never sell, the stocks you hold will eventually be destroyed.

Hendrik Bessembinder, professor of competitive business at Arizona State University, has shown that most shares underperform cash over their lifetimes for this reason.

This same fate can befall funds if they fail to pivot from one strategy to another at the right time. For example, if or when US big tech stops outperforming, how will Scottish Mortgage Investment Trust fare?

You therefore need an exit strategy, such as that suggested by Meb Faber, chief executive officer of Cambria Investment Management. This involves selling a stock or fund when its price drops below its 10-month moving average. If you don't follow this strategy, use something else like it.

Jessica Ayres, financial adviser at Timothy James & Partners, says:

A key objective is to buy a new home worth about £1m when you leave your current jobs. Consider how you will finance this, as you have not specified your earnings potential as civilians or if there will be a gap in your earnings while you establish new careers. If you sell your current home for £480,000 you will need to find a further £573,750 to complete the purchase. A £1m new home plus £43,750 stamp duty land tax, and legal and agents' fees of about £10,000, adds up to £1,053,750. After the sale of your home for £480,000 this leaves a £573,750 shortfall.

You should be able to get a mortgage of £340,000 even if you have no income other than your combined military pensions of £68,000 per year. You would probably need to have combined earnings of £114,750 per year, and no debts or adverse credit history, to get a mortgage of £573,750.

As you are liable to higher-rate tax, make use of all tax wrappers and allowances to maximise the return on your investments. But you should not contribute to pensions as you will breach the lifetime allowance when you draw your military pension. You should redirect future investments into Isas. Crystallise gains made in your ‘play portfolio', offsetting them against your annual CGT allowance, and reinvest them in Isas.

Your £40,000 cash Isa could be converted into an investment Isa to target more tax-free growth. Just ensure that you hold enough cash to cover emergencies.

But your husband should contribute to a pension so that he can claim back tax. And if he wants to contribute to a Lisa as an alternative to or alongside pensions, he needs to open one before he reaches age 40. A Lisa is attractive due to the 25 per cent annual bonus, but a pension is more attractive for higher-rate taxpayers.

I suggest earmarking your Sipp as an efficient way of passing funds onto your children. Pensions are outside your estate for inheritance tax (IHT) purposes, so if it is left invested for the children the final lifetime allowance charge at age 75 will be just 25 per cent – much less than the current rate of IHT.

You should also consider junior investment Isas for your children as they benefit from tax-efficient growth. You can contribute up to £9,000 per year to them, and I suggest balancing investing in these with making contributions to their Sipps. This would mean that your children have a long-term investment in the pensions but also, from age 18, accessible funds in their junior Isas.

The addition of a multi-asset tracker fund such as Vanguard LifeStrategy 80% Equity (GB00B4PQW151) would add low-cost diversification to your children's accounts and the prospect for long-term growth. If you are happy with the existing holdings, you could add this fund to balance their portfolios.

Annual growth of 7 to 8 per cent is ambitious for a moderate risk investor. Your portfolio is actually high risk, but your guaranteed military pensions and future state pensions allow you to take risk.

Your investments are entirely invested in equities, although with your cash holdings this gives an 80/20 split, in line with a high risk investor allocation.

Your investment portfolio is also highly concentrated, with 49 per cent of your Isa in Royal Dutch Shell. Overall, your investments are capital growth and tech focused so have a high-growth tilt. Although you have some stocks which balance this out, think about diversifying across company types, sectors and jurisdictions – particularly as value has had a resurgence and inflation could be on the horizon.

Investment trusts add the risk of gearing (debt). For example, Scottish Mortgage had gearing of 6 per cent, Edinburgh Worldwide Investment Trust (EWI) 3 per cent and Polar Capital Technology Trust (PCT) of 2 per cent, as of 8 April. But this can also offer growth prospects. Just be aware of a trust's level of gearing when considering investing in it.

If you want to keep fees low, build around your holdings by adding trackers such those in the Vanguard LifeStrategy or Legal & General index ranges. Trackers can be used to add different assets – not just equities. Also add a few focused, top-performing active funds to aid the portfolio during periods of volatility and compliment the cheaper trackers that will fall in line with markets.