What is the best way to generate £25,000 a year from my pensions?

Rahul is age 64 and earns about £100,000 a year. His wife is age 61 and works as a consultant in the NHS. They will both retire this year.

Their son is his 20s and works in financial services.

Rahul and his wife’s current home is worth about £650,000 and is mortgage free. They will let it from April for £3,000 per month but this will go to their son to whom they have transferred the ownership of the home. They will move into his wife’s second home which is worth about £1.25mn and has a mortgage of £540,000.

“We plan to travel when we retire and estimate that we will each need £35,000 a year to cover our expenditure,” says Rahul. “I would also like to set aside £50,000 for my son’s wedding and to buy him a new car.

“My wife has withdrawn her pension pot following pension freedoms. This is worth approximately £800,000 and was derived from her superannuation. 

“When I retire next month I will live off my investments. I would like them to make a total return of about £25,000 a year from October 2023 when my State Pension will start paying out about £9,300 a year. My investments include a self-invested personal pension (Sipp) worth about £750,000 and a workplace pension worth about £127,000. I contribute about £500 a month to this and my employer puts in the same amount.

“I have also recently transferred £75,000 from my individual savings account (Isa) into my Sipp to take advantage of tax relief and in view of my approaching retirement. I did this by carrying forward unused pension allowances from previous tax years.

“I plan to withdraw my pensions tax-free lump sum, which is worth about £225,000, in one go when I retire. I will spend about half of it on a number of projects I want to undertake. And I will invest the remainder in suitable investments to help generate the £25,000 to £35,000 a year I need to cover my living expenses. By doing this I hope not to have to pay any income tax for three to four years, and to be able to leave the rest of my investments untouched until I need to start drawing from them to cover living expenses.   

“I have been actively managing my investments since 2015, and occasionally invested in the 20 years prior to that. I prefer investing in funds as I got ‘burnt’ trading direct share holdings many years ago. I held around 20 to 25 investments until about five years ago but have since gradually whittled that number down.  

“I have a moderate attitude to risk and would be prepared for the value of my investments to fall, at most, 15 per cent in any given year. During March 2020, I watched with horror as my Sipp lost all the gains it had made over the previous five years, although, thankfully, it recovered quickly. But the value of my overall portfolio fell about 15 per cent over the three months to the start of February – even before the recent volatility following Russia’s invasion of Ukraine.

“So I wondered if I should rebalance my portfolio to reduce exposure to equities in favour of investments uncorrelated with markets – especially as I think I have largely achieved my investment objectives? I have already recently invested £70,000 in Secure Income REIT (SIR) and £75,000 in WisdomTree Physical Gold (PHGP). And I’m thinking of investing in Ruffer Investment Company (RICA), Capital Gearing Trust (CGT) or a similar wealth preservation fund.

"I also recently sold a £70,000 holding in Baillie Gifford Japan Trust (BGFD).

"That said, I am also wondering whether to invest in Baillie Gifford Positive Change (GB00BYVGKV59) or a similar fund which takes an environmental, social and governance (ESG) approach. And I had thought of adding Lindsell Train Global Equity (IE00BJSPMJ28) or a similar global equities fund."

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:

Your objective of a total return of £25,000 a year from a £900,000 portfolio should be achievable with average luck. It’s equivalent to just 2.8 per cent of that value per year. And over the long run we can reasonably expect a diversified portfolio of equities to deliver at least that.

The problem, however, is that you are not well diversified. You have a big bias to longer-term growth stocks which include Indian and Chinese equities, and UK micro-caps. You have even bigger holdings in Scottish Mortgage Investment Trust (SMT) and Fundsmith Equity (GB00B41YBW71). These have delivered wonderful returns in recent years, but done badly since the autumn as big tech and US growth stocks have de-rated.

This might just be just a dip. But there is a small danger that it’s the start of something worse – a longer-term de-rating. When highly valued stocks fall they can drop a long way. For example, the Nasdaq Composite index fell 75 per cent during the 2000 to 2002 tech crash. One reason for this is that momentum effects can go into reverse if investors who had chased the uptrend get out during the downtrend.

We cannot quantify this probability and we don’t need to. For you, perhaps, capital preservation is more important than capital growth. This means having a portfolio which is more resilient to shocks, and protected against low-probability but high impact risks.

One way to achieve this is to shift to a more diversified equity allocation by holding a global equities tracker fund. There are also several investment trusts that hold larger UK defensive stocks which might be a partial diversifier to growth stocks.

Also consider non-equity assets as you don’t need to be fully invested in equities to achieve a 2.8 per cent total return. But I’m not sure that you need a wealth preservation fund to reduce your portfolio's risk. A big danger is that the past won’t resemble the future. For years, achieving good risk-adjusted returns with diversified portfolios has been child’s play, because equities and bonds have been lightly correlated meaning that losses on one have been offset by profits on the other, and both have delivered nice long-term returns. But this might change.

If central banks raise interest rates in the coming months, which is more likely if the Russia-Ukraine war ends well, what has happened recently could continue – a sell-off in both bonds and equities. In such an environment, wealth preservation funds would struggle and you would be better off with plain old cash.

Your physical gold holdings are good portfolio diversifiers. But if we get a satisfactory end to the war and or bond yields rise, the gold price will fall back. Think of gold as insurance which pays off well in bad times but loses you money in good times.

Think also about your plans for bequests. If you want to maintain the real value of your wealth over the long run, you probably need to have high equity exposure because safe assets, for now, offer negative real returns. If, however, you are only investing for yourself you can afford to have a safer portfolio, albeit one whose value dwindles over time as you consume your capital.

Shelley McCarthy, managing director at Informed Choice, says:

Undertake a cash flow forecast and make a financial plan to help you understand how sustainable your income requirements are and what level of risk you actually need to take.

I think that an income of £25,000 a year from a portfolio worth about £788,000, after you have spent some of your tax-free cash on projects, should be achievable. This equates to a yield of around 3.17 per cent.

But reconsider taking all of your tax-free pensions money in one tranche. Assets in pensions are in a tax-free environment, so why remove the tax free cash and reinvest it in a vehicle that is likely to be taxable?

The amount of tax-free cash could grow over time. If your pensions continue to grow, the available tax-free entitlement will also increase, subject to overall Lifetime Allowance limits.

Pension funds fall outside your estate for inheritance tax (IHT) purposes and retaining access to tax-free cash can help if you have future lump sum capital needs.

And the tax-free cash withdrawals can be spread over a number of years, reducing the gross withdrawal amount to provide the same net income.

It is also often preferable to have withdrawn your tax-free cash allowance from your pension by age 75. If you die before age 75, the entire fund can be passed on tax free to beneficiaries. If you die after age 75, your beneficiaries pay income tax on withdrawals from the pension. The amount that you would have been able to access tax free would be taxable in your beneficiaries hands. So to minimise taxation, you could potentially withdraw the tax free cash and gift it to them. If you survive for seven years after doing this, the amount given would fall outside of your estate for IHT purposes.

It would also make sense to withdraw a taxable income of at least £12,570 in the 2022/23 tax year to use your personal allowance, prior to your State Pension coming into payment. Even when your State Pension starts paying out, there is likely to be scope to top up your taxable income to fully use your personal allowance.

There is a significant mortgage outstanding on the property into which you are moving. Consider how you might repay it. Or if you plan to maintain the mortgage, think about whether this will be sustainable if interest rates rise significantly. You could repay a large chunk of the mortgage by taking the available tax-free cash lump sums from both your own and your wife's pension pots. But they would then need to generate a significantly higher yield of nearly 4 per cent to produce the income you require. It would also mean that you do not have money to undertake the projects or make the gifts you have in mind. 

Regarding the risk that you are taking with your pensions, you seem overweight in equities, given your risk profile. You could increase the level of cash that you hold. Doing this could also prevent you from having to withdraw from your investments when their value has fallen. Although cash returns very little and inflation needs to be considered, there is an argument for increasing your allocation to it from a risk management perspective.