How can we retire in 10 years on £50,000 a year?

Richard is age 47 and his wife is 52. He earns £130,000 per year, and also typically gets bonuses of between £30,000 and £50,000, after tax. His wife earns £50,000 a year. They have three teenage children who are likely to spend another five to seven years in full-time education.

Their home is valued at £1.1m and has a £150,000 mortgage which they plan to pay off in the next five years. 

“We would like to reduce our work commitments in five years’ time and, by the time I am age 57, be in a position to semi-retire and live off income from our individual savings accounts (Isas) and freelance work," says Richard. "We would like to have an income of £50,000 per year in today's money.

"I have a workplace pension to which my company contributes the equivalent of 15 per cent of my salary a year. It has a value of about £28,000. I have a self-invested personal pension (Sipp) made up of former workplace pensions and my own contributions which has a value of about £365,000. And I have an investment Isa worth about £179,000 into which I have made the full annual contribution for the past four years.

"My wife has a pension worth about £130,000 and Isa worth about £60,000. These are managed by an independent financial adviser because we do not want all our investments to be managed by myself. My wife's pension and Isa are invested in direct shareholdings and funds, and have a moderate to conservative risk profile.

"We intend to make the full annual contributions to each of our Isas for at least the next five years, after which we may need to reduce what we put in.

"We also have cash savings of £10,000 – equivalent to 1.5 months of our outgoings.

"Are our portfolios, assuming average growth for my wife's Isa and pension, structured appropriately to enable us to reduce our work commitments in 10 years’ time and get an annual income of £40,000?

"I have a fairly high risk appetite. My investments' value has fallen by up to 30 per cent in the recent past but I remained invested. My Sipp, on average, has achieved growth of 10 per cent a year for the past 10 years. My goal is to continue to get similar rates of growth with it and for our overall portfolio to grow.

"I hold steadier income investments alongside riskier growth stocks. I have tried to diversify my holdings across geographies and sectors, although I hold quite a few tech stocks, real estate investment trusts (Reits), and companies which target alternatives to cash payments such as PayPal (US:PYPL), Visa (US:V), Bango (BGO) and Fonix Mobile (FNX). I think that such technologies will become more pervasive and are part of a longer-term trend which I would like to benefit from.

"I avoid active funds because of the compound impact of fees and my belief that the majority of them fail to outperform the market substantially over time. I think I am better off investing via exchange traded funds (ETFs) although I hold some active funds to diversify risk.

"I try to ensure that no holding accounts for more than 5 per cent of my investment portfolios, but am concerned that I have too many direct share holdings."

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:

There’s a lot you are doing right here. You’re adding to your portfolios each year through pension and Isa contributions. This matters because you cannot assume that the 10 per cent a year returns you’ve made in the past few years will continue. Prospective real returns on bonds are now minus 2 per cent, which means that 10 per cent returns on equities would require a premium of around 12 per cent a year. That’s far above the longer-term average and farther still above what can be justified by theory.

So you should budget for modest returns. This means that if you want an income of around £40,000 a year in 10 years’ time, which would require you to have total assets of £1m-plus in today’s money, you will need to save a lot.

My pessimism might be misplaced but if it is, the additional money you save could enable you retire earlier and enjoy your money.

If you invest in actively managed funds over the long term, the risk is, as you note, that their fees compound nastily with no assurance of outperformance to compensate for this.

Some active funds have done well in recent years. But these are often ones which have successfully backed big tech stocks such as Amazon.com (US:AMZN), Apple (US:AAPL) and Microsoft (US:MSFT). And their outperformance might not last. They are now so highly valued that they are, in effect, pricing in sustained monopoly power. And Amir Sufi, professor of economics and public policy at the University of Chicago Booth School of Business, and his colleagues have shown that falling long-term interest rates tend to disproportionately benefit bigger companies. So if the decline in yields stops or goes into reverse, so too might the outperformance of big tech. And this would pose a risk to your portfolio because it has large holdings in stocks such as Alphabet and Amazon.

Rising interest rates might also be a danger for your Reits because they are often bad for property prices. 

But this doesn’t mean that you should sell quickly. Momentum is still on your side and this is a powerful force. What it does mean is that you – like all active investors – need some kind of exit strategy. Selling investments when their prices fall below their 10-month averages is one such strategy. Although it doesn’t always work, it has the great virtue of protecting investment portfolios from the long and deep bear markets that really destroy wealth.

Some might argue that not allowing any holding to account for more than 5 per cent of your investment portfolios means that they are over-diversified. But this problem is mitigated because not many of your holdings are active funds with relatively high charges.

However, diversification reduces your exposure to any individual stock at the price of increasing your exposure to general factors. The most important of these factors is ordinary market risk: if the market falls so too will any well-diversified portfolio of equities.

That said, your portfolios are also exposed to another factor – defensives – thanks to your holdings in Unilever (ULVR), Diageo (DGE), ContourGlobal (GLO) and funds such as City of London Investment Trust (CTY). This is sensible, not so much because defensive stocks hold up well in downturns, but because they tend to outperform over the long term.

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

The past decade has been a particularly strong for markets due to low interest rates, quantitative easing and the explosive growth of big tech. But there is no guarantee that markets will generate such strong returns over the next decade. That said, your goal of taking £40,000 a year from your portfolios in 10 years’ time is realistic and should be achievable even if market performance falls short of 10 per cent a year.

Your investment portfolio is well diversified with exposure to a good range of growth stocks. But you have too many holdings, particularly as you are still working full time, which means that you must find it difficult to find time to monitor so many investments.

Some of your funds and ETFs are arguably redundant. For example, Vanguard FTSE All-World UCITS ETF (VWRL) holds several stocks which you also hold directly. But Molten Ventures (GROW) and Scottish Mortgage Investment Trust (SMT) work well alongside your equity holdings because they add an element of differentiation. Try only to hold active funds and ETFs which offer exposure to areas of the market which are difficult to access directly such as smaller companies, private companies and emerging markets.

Non-equity funds can generate good levels of income while adding an element of stability to a portfolio, and you have a great range of property trusts which are predominantly focused on logistics. This segment of the property market has held up well throughout the pandemic due to increased demand for deliveries, and this is a trend that is likely to continue. You could consider some other alternative assets such as digital infrastructure and music intellectual property rights.

Two areas that I think that your portfolio lacks exposure to are healthcare and energy. The quest to find a Covid-19 vaccine has led to significant advances in many therapy areas which should lead to enhanced rates of future growth. Companies such as Danaher (US:DHR) and Thermo Fisher Scientific (US:TMO) should continue to benefit. Or for exposure to this area via funds options include Polar Capital Healthcare Opportunities (IE00B3NLDF60).

If global leaders are to reach their goal of carbon neutrality, trillions of dollars will need to be spent on clean energy technology and infrastructure upgrades. Beneficiaries could include UK-listed SSE (SSE), which is now a global leader in offshore wind, and industrial gases company Linde (US:LIN), a leader in hydrogen. For exposure to these areas, Schroder Global Energy Transition Fund (GB00BF781C09) is also worth considering (see chart).