How do I get the most out of my Sipp?

Joe is 43 and earns £44,000 a year. He has £214,000 in two workplace pensions which he leaves invested in default funds but he also started running a self-iInvested personal pension (Sipp) around a year ago and has a small amount in an individual savings account (Isa). Joe’s plan is to maximise his Sipp portfolio growth for 10 to 15 years before switching to an income approach.

He also has a home worth around £350,000 with a small remaining mortgage (see box-out) and an investment property worth around £120,000 with no mortage that currently generates a pre-tax income of £525 a month. For now, Joe sees himself ultimately selling these and buying a more expensive property.

“I currently have no family of my own and am unmarried,” he says. “Although this may change I would like to eventually sell and combine both of my properties to purchase a larger property. My investments would then be used to generate enough income to support this.

“I'm not sure about the exact age at I will retire at but think maybe in my mid-50s. If I sell both my properties and purchase another one worth around £500,000 for my retirement, the income I have will need to cover the costs of running such a property. I'm guessing here but that would perhaps be £30,000 per year.”

Joe notes that he is relatively new to investing, adding: “I have been learning by making small investments within my Sipp and stocks and shares Isa, by taking £50 a month from my investment property. 

“My current strategy is to invest £100 in a fund or share to begin with and watch how it proceeds. I prefer investing in funds rather than direct share holdings because the charges take quite a sum of the original investment and often I rarely reach my original investment very quickly. I have followed suggestions in Investors' Chronicle, and my initial £20,000 investment has increased and decreased. 

He adds: “I am willing to be a little more adventurous with my Sipp as would like to maximise its growth. With my stocks and shares Isa I tend to be more conservative as fear that I could lose money that I may need access to outside of my Sipp.”

Joe is not considering any new investments in the near future because of a desire to keep his number of portfolio holdings down. His last three investments were in the Threadneedle Enhanced Commodities (LU0515770435), BlackRock Gold & General (GB0005852396) and Ninety One Global Special Situations (GB00B29KP103) funds.

When it comes to workplace pensions, Joe contributes 6.25 per cent of his salary into his current scheme with his employer contributing 7 per cent. “In the future I may transfer all of my pensions in to one Sipp if I find managing the £20,000 becomes easier,” he says.

Joe's Sipp holdings

NONE OF THE COMMENTARY BELOW SHOULD BE REGARDED AS ADVICE. IT IS GENERAL INFORMATION BASED ON A SNAPSHOT OF THIS INVESTOR'S CIRCUMSTANCES.

Chris Dillow, Investors' Chronicle's economist, says:

One issue you have here is how to get a diversified portfolio when you have relatively small sums to invest meaning that dealing costs are onerous. But there’s a simple solution: a tracker fund.

This is, in effect, a fund of all equity funds, so diversifies across all equities and fund managers. And given the evidence that trackers outperform most fund managers over the long term, you can get such cheap and effective diversification with no loss of performance.

What’s more, when you need to economise on dealing costs you need long-term investments which you can safely leave alone. Tracker funds give you this, whereas other stocks and funds do not. A big reason for this is that long-term corporate growth is unpredictable (and often unsustainable) so you cannot simply buy and hold individual stocks for the long term. This means that you should back the field rather than particular horses.

Actively managed funds might seem low-cost in the short term but they are not in the long term. An extra half percentage point of annual management fees could easily cost you an extra £750 for every £10,000 you invest over 10 years. There’s a reason why fund managers are well paid and have expensive offices.

Of course, a tracker fund doesn’t feel diversified, and it’s certainly no fun. And you want to take more risk in the hope of getting better returns. You must, however, be careful here. But some risks do not pay. Smaller speculative stocks are riskier than others, but they don’t deliver higher returns. The FTSE Aim index, for example, has underperformed the FTSE All-Share index by 4.1 percentage points a year over the past 20 years, with a nominal annualised total return of just 2.2 per cent. Similarly, higher beta stocks – those which are more sensitive than others to ups and downs in the overall market – have also underperformed over the long run.

Instead, it is defensive stocks that offer the better long-term returns (although momentum stocks also outperform you cannot exploit this without trading a lot.) Do not think, therefore, that you need to take on extra risk to achieve higher returns. Some risks don’t pay.

You want to eventually sell your investment property. But why 'eventually'? Yes, that 5 per cent-plus yield is attractive. But house prices now are more overvalued than equities, and there’s a danger that they’ll be harder-hit than shares by rising interest rates (rates might not rise further, but if they don’t it’ll be because the economy is in recession, which is bad for house prices too). You might therefore want to consider testing the market now by seeing what offers you get for that property.

You might also consider whether you really want to trade up your residential home. Doing so would tie up money you could otherwise use for retirement. Do you want to do that?

Also, I think that you’re wise for now to hold onto your two workplace pensions rather than roll them into your Sipp. There’s something to be said for diversifying management risk if this can be done cheaply.

Gavin Wood, head of private clients at Beckett Financial Services, says:

It is good to see you taking an active interest in your affairs and wanting to learn how to best manage the investments. Starting the self-management with small amounts and leaving the larger funds untouched at present is sensible, as it avoids harming the accrued funds as you are learning.

The two workplace pensions form a good underpin to future retirement income. However it is a little concerning that they are both invested in default funds. Default funds tend to have a range of risk-based options, however experience has shown that often investors are put in the ‘balanced’ one or a lifestyling option. Both of these may be unsuitable for you based upon your retirement plans. I therefore recommend that you liaise with a financial planner to assess the merits of transferring the previous employer’s scheme into your new workplace pension. The rationale for this being that you can potentially have greater overall economy of scale and a more consistent investment approach directly linked to your timescale for retiring and personal attitude to risk.

Pension rules have changed so that from 2028 the minimum age at which you can access pension benefits will be age 57.  Your state pension will not commence for a further 10 years as the state pension age is rising to 68, so you will have around a decade of having to fully fund retirement without any state assistance.

You have 'guessed' that you will require £30,000 a year to meet the running costs of your new future property. It is not clear whether you have factored into this money required for fun. So would be sensible to undertake some cash flow modelling to assess what size of overall investment fund you will need at age 57 to provide the income you need to support the lifestyle you would like to have. Looking that far ahead with certainty is hard, but a starting point for this could be to assess what level of expenditure you have now and increase this annually by, say, 3 per cent to achieve the notional income figure needed.

That will then help your financial planner to see whether the investment strategy being undertaken across all of your assets is sufficient to generate that size of overall retirement fund.

The cash flow modelling should be revisited regularly to ensure that your financial plan remains on track and retirement at your preferred age is realistic. Much can happen over time and it is vitally important that plans are reviewed and tweaked where necessary.

At present the total rental income received is £6,300 gross a year. When added to your earned income this just nudges you into the 40 per cent tax bracket, but only just, by £30 if you have a standard tax code. You can claim higher rate income tax relief on that amount of pension contribution. Not a major issue now but one to watch if your earned income or rental income increases.

You state that you are currently investing £50 per month from the rental income. If you do not need the other £475 per month for current living expenses it would be sensible to allocate this to additional pension contributions or extra investment into the stocks and shares Isa. The surplus income will help to boost the overall fund available and you cannot underestimate the power of compound growth on contributions made now. I would suggest the pension route, as a net contribution of £475 would be grossed up to £593.75. An overnight return of £118.75 or 25 per cent. It also worth checking whether your employer will pay in more if you increase your contributions to the workplace scheme, rather than paying them into your Sipp.

One area of concern is that your cash reserves are relatively modest. You need to consider how you would continue to fund both mortgage payments and your lifestyle if your earned income were to cease. You give no reference to any income protection plans, so potentially arranging a form of insurance to protect against loss of earnings, or redirecting the £475 surplus rental income into cash accounts to boost that, would be a worthwhile exercise. Everybody's capacity for weathering loss of income is different but it is one which needs careful consideration.

You do not state whether you have a will. Although you are unmarried it would be prudent to have a will so that your properties can be passed to your preferred beneficiaries. You should also complete a pension death benefit nomination form for the Sipp and workplace pensions to ensure that your preferred beneficiaries receive these.

With regards to selling both properties to combine the funds to buy a bigger home, you need to be mindful of the fact that your investment property would be subject to capital gains tax (CGT) on any growth above the CGT allowance prevailing at that time (currently £12,300). The level of gain will be added to your income to determine the rate of tax. According to the information you have given, your gains would be taxable at 28 per cent (including the 8 per cent second residential property surcharge). If your marital position changes in future you will be able to use your spouse’s annual CGT allowance to mitigate some of the gain. There is no CGT on gifts between spouses so if you gave your spouse a share of your investment property after marriage you could increase the level of tax-free return from the asset upon sale.

You state that you are more conservative with your stocks and shares Isa as you feel you could lose money that you may need access to outside the Sipp. If you are viewing this as part of your emergency/peace of mind fund I would question whether stocks and shares are the best asset for it. It is important the cash reserves are at a level which would enable you to cover loss of earnings. Even with a more cautious approach within the stocks and shares Isa, you would not want to have the double whammy of loss of income coinciding with a stock market downturn. Therefore, boring as it may seem, it may be that keeping a certain amount on deposit or in Premium Bonds to cover emergencies is a better course of action. That will allow you to invest the Isa funds alongside the Sipp funds to generate better returns and to fully maximise the Isa's tax-free advantages.

Tony Yousefian, portfolio manager for Beckett Asset Management, adds:

You have some very interesting holdings; however, to try and achieve your objective in a structured manner, you need to establish a few ground rules (some of which you have already established). In the interest of time and space limitations, I will keep this brief:

1) Investment objective: You have already stated this is capital growth.

2) Investment time horizon: Your time horizon is 10 to 15 years.

3) Investment amount: As per your current holdings.

4) Attitude to risk: This is crucial to establish as it will be instrumental in you ultimately achieving your desired returns. You have already stated that you are prepared to take some risk with some of your investments and not with the rest, as you may need them as accessible emergency capital. While I understand your rationale, you are better off keeping your emergency funds in cash and separate from your investments. You need to establish your overall attitude to risk not by wrapper but in general terms. The wrappers only dictate how you can access the capital; ultimately, the success or failure of the plan depends on where the monies are invested. In your case, I will assume a medium tolerance to risk.

The final point is to ensure that different asset classes are used in your overall portfolio to provide you with diversification. This is crucial as up to 75 per cent of the returns in a portfolio are derived from asset allocation, and only 20 per cent is down to fund/stock selection. The remaining 5 per cent is market timing, and it is marginal in the overall return and best ignored.

The approach set out above can be used as a framework to construct a portfolio that has a balanced approach to risk and is made up of the following asset classes:

• Global equities                65 per cent
• Alternatives                     14 per cent
• Bonds                              12 per cent
• Property                           9 per cent

Global equities

There are plenty of funds that provide exposure to global equities. Three different funds will be more than adequate. Remember, diversification is not how many different lines of investments you have. It is about holding different asset classes that react differently in different market conditions. Consider putting 26 per cent of your portfolio in UK equity funds and 39 per cent in global ex UK equity funds. This part of your overall portfolio would drive investments where the objective is long-term growth.

Alternatives

Here, you would typically invest in funds that provide returns independent of standard asset classes, such as equities, bonds, and property. It would help if you were invested in funds with low volatility and consistent returns over a long period. The primary purpose of this part of your investments is diversification and long term an element of capital appreciation.

Bonds

The purpose of this part of the portfolio is diversification and long-term capital preservation. Some active fund managers have an excellent track record.

Property

Property funds have had a torrid last few years, but this does not detract from their diversification characteristics in a well-balanced portfolio. In the long-term traditional bricks and mortar funds are an excellent source of stability in a portfolio and have traditionally delivered capital growth as well.