How do I generate a regular and reliable income of £40k-£45k a year?

Natalie is 62, divorced and earns £10,000 a year. She has two adult children. Her home is worth about £600,000 and mortgage-free. She also owns three buy-to-let properties worth about £680,000 in total, which are mortgage-free and produce income of £31,000 a year before tax and costs.

"I would like a regular and reliable income of £40,000-£45,000 a year from when I am age 65," says Natalie. "I am due to receive the full state pension. And I might sell my buy-to-let properties in different tax years and invest the proceeds in my self-invested personal pension (Sipp) and individual savings account (Isa) within the next five years.

"I envisage capital gains tax (CGT) on gains of approximately £290,000 before any allowances are deducted. So, realistically, what kind of income can I expect from my investments?

"Until now, my investments have been allocated for growth to build up my retirement pot. But I now want more income although, ideally, I would like income and growth. I also want to pass my assets on to my children and will leave my Sipp to them if I die earlier than expected.

"I have a low to medium risk appetite but could my Sipp produce higher growth without taking too much risk? A substantial portion of it is invested in Vanguard LifeStrategy 20% Equity (GB00B4NXY349) and bonds so it is probably not growing as much as it could, and I am thinking of adding Vanguard LifeStrategy 60% Equity (GB00B3TYHH97).

"I have been investing for 17 years, and buy investments during dips and hold them. I had tried investing in 'get rich quick shares' such as Inland Homes (INL) and Neil Woodford funds, but these did not work out. So I plan to sell Inland Homes when its share price has risen enough, as well as ITV (ITV).

"I now stick to what appear to be big, safe companies and reliable funds. I am thinking of topping up my holdings in Scottish Mortgage Investment Trust (SMT), Walt Disney (US:DIS), Diageo (DGE)  and Monks Investment Trust (MNKS). I might also add funds that produce both income and growth, such as Finsbury Growth & Income Trust (FGT) and Murray Income Trust (MUT).

"I am concerned that I am paying too much in fund fees. My portfolio's costs add up to more than £3,700 a year, which includes my independent financial adviser’s fee, investment platform charges and cost of investments."

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

John Moore, investment manager at Brewin Dolphin says:

It's good practice ahead of retirement to review your financial positioning and plans for the future. You need the right balance of income, flexibility and investments with a risk profile you feel comfortable with.

Your capital gains tax position following the sale of your buy-to-let properties presents a challenge to maximising the wealth available. The tax on at least some of the proceeds is likely to be 28 per cent. I suggest staggering the sales over different tax years and maybe retaining one property as an alternative source of income. This would also be a good idea in view of the limits on pension contributions. 

Assuming that you have no carry-back allowance - although do check this - you can only contribute £10,000 a year to your Sipp, so £50,000 over the next five years if your salary remains the same. You could make total Isa contributions of £100,000 over this five-year period so at most add £150,000 to these two pots.

A total CGT bill of £290,000 for the sale of your three properties equates to an average gain on each property of around £97,000 or taxable gains after your annual CGT allowance of £85,000, which could mean CGT of around £24,000 on each property. But if you sell two properties and realise around £430,000, after paying CGT you would have £382,000 to invest. You could invest £50,000 of this in your Sipp, £100,000 in your Isa and the remaining £232,000 in a general investment account.

Adding these amounts to the existing investments would result in a good balance across different wrappers, and help with income flexibility and tax efficiency. If you continue to achieve the same level of yield from the buy-to-let property and take a 3 per cent yield from each of the investment pots, you could receive an annual income of about £36,000. With the state pension, this would provide an income level at the upper end of your £40,000-£45,000 target range, before tax.

Only take as much risk as you are comfortable with. If you have a low to medium risk appetite, 60 per cent equity exposure overall may not be suitable. But you could maybe have some such exposure to get the returns you need to meet your requirements and aim of passing capital on to your children.

Your approach to risk and investment should generally be consistent, but could vary a little to suit the specific mandate of each investment pot and take into account cash additions. So as the Sipp probably has the longest duration of all your investment pots and is likely to be the main source of capital that is passed on to your children, in time it should have a slightly higher risk level than the other pots. But this should only be after you start to receive the state pension. Until then, the Sipp should be a little more cautious as you might need to draw income from it before you start to receive the state pension.

You can adapt your asset allocation approach as you invest new money into your accounts. And when you are receiving the state pension you should regularly review your circumstances, and investment approach overall for each pot. You may need to take a total return approach to generate the levels of income withdrawal set out above, and should generate this from a diverse range of investments. The key to this approach is to regularly review your income requirements, approach to risk and balance of investment exposure.

The Sipp holdings have some of the same exposures as each other, but there are ways you could simplify this portfolio. You could invest around 75 per cent of the Sipp in Vanguard LifeStrategy 60% Equity, which would achieve a clear asset allocation and maintain a small exposure to emerging markets, as the Sipp currently has. The remaining 25 per cent could be invested in alternative assets that Vanguard LifeStrategy 60% Equity does not invest in, and that could generate income and help to balance the portfolio.

Personal Assets Trust (PNL) could help to preserve capital over the longer term and provide regular income. HICL Infrastructure (HICL) and Greencoat UK Wind (UKW) offer exposure to infrastructure with some degree of inflation protection, and much of their return is in the form of income. TR Property Investment Trust (TRY) takes a nimble, opportunistic approach to getting growth and income from commercial property. These trusts have ongoing charges of between 0.73 per cent and 1.38 per cent. Although you are not happy with higher charges, they offer exposure to assets that you could not invest in directly yourself, so are worth paying for to access different assets and achieve good portfolio balance. Also, investment trusts can provide more durable and less volatile income streams.

You could simplify the Isa allocation in a similar way, but only invest 50 per cent of the Isa in Vanguard LifeStrategy 60% Equity so that it could be more focused on generating income. You could allocate 30 per cent of the Isa to direct equity holdings and global investment trusts for overall portfolio balance and income. National Grid (NG.) and Nestle (SWI:NESN) could be defensive sources of income, while Shell could provide cyclical income and a hedge against oil price inflation. Henderson International Income Trust (HINT) and Scottish American Investment Company (SAIN) generate income from mainly different sources which they aim to maintain and grow, if necessary by drawing from revenue reserves.

You could allocate the remaining 20 per cent of the Isa to alternative assets for diversification and income. Muzinich Global Tactical Credit (IE00BYV1C692) offers an income of around 3 per cent by mainly investing in bonds with long-term total returns in mind. Standard Life Investments Property Income Trust (SLI) generates a quarterly income of around 4.5 per cent by investing in commercial property. And 3i (III) invests in private equity, a risky area but which could generate excess returns.

I would hold £40,000 of the remaining £232,000 property sale proceeds in cash with a high rate of interest or a NS&I product. This should cover a years' worth of income during periods when markets are volatile and it might not be a good idea to draw from, say, the Sipp. The cash allocation should be reviewed on a regular basis.

The remaining £192,000 could be invested in more volatile and risky assets. During periods of strong performance you could sell down chunks of these and offset the profits against your annual CGT allowance, and also offset losses against gains. When you have invested all the proceeds from property sales, you could transfer assets from the general investment account to the Isa each year up to the value of your allowances.

Around a third of the general investment account could be invested in direct equity holdings to widen out the overall positioning. Microsoft (US:MSFT), GSK (GSK), Intercontinental Exchange (US:ICE), Stryker (US:SYK), Unilever (ULVR), Kone (FIN:KNEBV) and Admiral (ADM) could generate income of around 2.25 per cent, and this level of income could grow due to their strong market positions.

Another third could be invested in defensive assets such as index-linked UK government bonds and income-generating alternative assets. Renewables Infrastructure (TRIG) offers overseas exposure to wind and renewables, has a strong yield and would balance Greencoat UK Wind's domestic focus. International Public Partnerships (INPP) has different exposures to HICL Infrastructure, but a similar scale and approach. And BH Macro (BHMG) provides a hedge against step changes in rates and volatility.

You could invest the remaining third in investment trusts with growth potential which also generate income. Trusts with a balanced and well-spread approach include Murray Income Trust, JPMorgan American Investment Trust (JAM) and Witan Investment Trust (WTAN). Although JPMorgan Mid Cap Investment Trust (JMF) has not performed well recently, there is a case for being patient and adding to it. Also consider Aberforth Smaller Companies Trust (ASL , which invests in the riskier types of potential turnaround situations that you used to, but selects them via a more forensic and diverse approach. This trust, Schroder Oriental Income Fund (SOI) and JPMorgan Global Emerging Markets Income Trust (JEMI) have good starting incomes and impressive income growth records. Polar Capital Global Healthcare Trust (PCGH), meanwhile, would broaden your healthcare exposure.

Nick Onslow, chartered financial planner at Progeny, says:

With a wide range of assets and this level of wealth, you need to work out what the best way to achieve your goals is. 

Your three buy-to-let properties generate £23,594 a year less an estimated 15 per cent in costs, net of tax. Your level of income will increase in four years when you are age 66 and start to receive the state pension, which is currently 9,627.80 gross a year or £7,702 net of tax. Your total net annual income will be around £31,296, so about £13,704 short of your maximum target.

Your Sipp, Isa and cash are worth around £478,000 at which value you would need a 2.87 per cent annual return after inflation and charges to meet your income shortfall without eating into the value of your capital. Even if you drew from these assets without them achieving any growth they would last approximately 24 years if inflation averaged at 3 per cent.

Your estate has a potential inheritance tax (IHT) liability of approximately £378,378. Although your Sipp is outside your estate for IHT purposes, and pays out tax-free to your heirs if you die before age 75, the value of the assets in it would be required to help cover this liability. Make sure that you have an up-to-date death benefit nomination for the Sipp as this money doesn’t fall under probate.

Also have an up-to-date will. If one or both of your children are named as the recipients of your main residence your estate will qualify for an additional tax-free band of £175,000. If you have not named either of them or their children as the heirs to your main home your estate's IHT liability increases by about £70,000.

The gains on your buy-to-let properties will be subject to CGT in the year of their sales at either 18 per cent or 28 per cent, or a combination of both. The first £12,300 of the gains can be offset against your annual allowance. I estimate that if you sell them over three tax years you will need to pay CGT of about £58,000 on gains of £290,000. This would leave you with £622,000 to invest.

With your existing investments, this would give you about £1.1mn to invest. Initially, you will require a 4.1 per cent return after inflation and charges to generate the level of income you require without reducing the capital value. This reduces significantly if you are prepared to draw down the capital and neither calculation includes your expected state pension of around £9,627.80.

Investing the maximum possible, currently £10,000, in your Sipp and getting 20 per cent tax relief annually and £20,000 in an Isa are the most tax-efficient ways to save. When you are retired, you could still save £2,880 a year into your Sipp until you are age 75 and get £720 tax relief a year.

Being able to use a wide range of tax allowances is the key to success. The main ones are as set out in the table beloe.

You could build a tax-free retirement income of £45,000 a year using a range of tax allowances as follows.

As stock markets are unpredictable and don’t give an even return, taking a regular income can mean you draw from investments in a falling market. This creates sequential risk requiring a greater return to compensate for this (see 'How to handle your portfolio in extreme situations', IC, 11 March 2022). I recommend having an emergency cash fund to cover any unexpected life events worth up to three years' of your income so that you do not have to draw from your investments in falling markets.

Although you have a low to medium appetite for risk, you are currently invested in a wide range of assets, some of which have higher risk levels, such as direct shareholdings. And your capacity for loss is on the higher side. Consider the overall blended risk you are prepared to take and the range of asset classes you want to invest in. The right mix of investments, managing costs and rebalancing a well-diversified, globally spread portfolio should give you the outcome you want. 

Vanguard LifeStrategy 60% Equity is invested globally and has a low ongoing charge of 0.22 per cent. Although over the past year it has fallen about 2 per cent, over the past 10 years it has returned 109 per cent [according to Trustnet, as of 9 June 2022].