How should I invest to generate a reliable income?

Gerry is age 74 and received £38,200 in the last tax year from the state pension, and three former workplace pensions which are inflation proofed or have an escalation of 2 per cent. He also received dividend income of £19,600 from his individual savings account (Isa) and £17,300 from his general investment account. And he received interest from cash savings of £1,240.

His home is worth about £450,000 and is mortgage free. 

"I am retired so want to continue producing a reasonably reliable income for as long as I need it," says Gerry. "I am in good health and have had some long-lived relatives, but have no family to fall back on so need to ensure that there is money available to pay for help later, if necessary.

"I would like my investments to grow – especially with the current upsurge in inflation – although do not have a specific return in mind. I draw dividend income from my two investment portfolios as I need it and, as I generally don't use it all, either reinvest it or put some into easy access cash accounts. However, I find that my cash reserve continues to creep up so wonder whether I should invest £30,000 to 50,000 of it? Or what would be a suitable size for a cash reserve? 

"I do not plan to sell investments to cover day-to-day expenses – I try to use the natural yield from my investments. And I have a solid income base, with the pension income and cash, so can ride out market dips and tolerate the extra risk of large equity investments. Also, over the 40 years that I have been investing, I have seen numerous dips in equity markets and have generally sat tight because they bounce back. 

"Very few people – even professionals – consistently outperform the market so I am happy to make returns near to those of the market. I hold quite a few tracker funds and exchange traded funds (ETFs), and what I consider to be conservative investment trusts. There are things I want to do more than constantly tweak a portfolio and I trade very little. Also, with over 50 different holdings I do not plan to add any new investments but rather add to existing holdings. 

"I plan to slowly reduce my number of holdings and this will include selling Keystone Positive Change Investment Trust (KPC). I am also considering reducing my holdings in Fundsmith Equity (GB00B4MR8G82) and Vanguard US Equity Index (GB00B5B74S01). 

"I also hold some investment trusts which are doing similar things to each other, but reducing these is a lower priority.

"My investments have a wide geographical spread, and I tend to like ones that pay a yield of between 2 and 4 per cent. But I have avoided bond funds since the early days of quantitative easing."

Gerry's total portfolio

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

James Norrington, associate editor at Investors Chronicle, says:

As a highly experienced investor you know what you like, and have a style that suits your capacity for and attitude to risk. You are also aware that your portfolio has too many holdings, and there is some duplication in terms of what the funds are aiming to achieve and invest in.

Simplifying your portfolio is a worthwhile objective. Prioritise asset allocation decisions and choose a few low-cost distributing ETFs as core holdings. Also maybe hold some investment trusts with strategies and managers you believe in to get exposure to themes or geographies where active management makes sense.

When deciding how much cash to hold there are two main considerations – your cost of living and how you manage the risk of peak-to-trough falls in the value of your portfolio.

Because your state and work pensions provide added security, and you have a decent sum in easy access cash accounts, you may feel no concern. But it’s a good discipline to regularly reassess your needs.  

Many investment trusts dip into their capital reserves to maintain their own dividends, even when payouts from investee companies are lean (something which is not always good for younger investors as the trust's future compounding power is diminished). Nevertheless, you should also have a bit of an extra 'cushion' to cover fallow spells when the portfolio generates less income.

Income investors should always factor in the chance of dividends being cut. Although you can sell shares and units to create your own dividends, what if you need to do this when markets are down, forcing you to crystallise losses? It’s circumspect to have an emergency fund set aside.

How you manage peak-to-trough falls is more nuanced. There hasn’t been an economic backdrop like this for decades: inflation is persistently high, exacerbated by an energy crisis and stifled trade, and productivity in western economies has been spluttering for years. 

Over the past 30 years, the best way to diversify risk and protect against equity bear markets was to split your asset allocation between equities and bonds. Before inflation started rising in 2021, it appeared to be treated by policymakers as a distant memory – the bête noire of the 1970s. With rising prices under control since the end of the 1980s, central banks got into the habit of slashing interest rates to support economies through shocks.

When interest rates fall, bond prices – which move inversely to yields – rise. This has often meant that government bonds, which are a safe-haven asset in times of fear, have made capital gains that offset falls in equities.

When the backdrop is inflationary, central banks don't have the option of calming stock markets with interest rate cuts. Double-digit levels of inflation won't persist but the days of struggling to reach a 2 per cent target are over for the foreseeable future. Although safe-haven properties will persist, government bond price rises are no longer likely to rise enough to fully offset falls in share prices, and it is possible that they could go down in tandem.  

So when it comes to controlling peak-to-trough falls in portfolios – something you should be more worried about as an older investor – you arguably need more cash.

Tom Planterose, senior portfolio manager at Sanlam Wealth, says:

You appear to have a preference for investment trusts. These types of funds can borrow money to leverage opportunities with a view to increasing investment returns. While trusts have some advantages, the allocation of your portfolio should ultimately come down to one key aspect – the need to take risk. The investment trusts you hold are almost all equity focused, with some exposure to property, but this could lead to lumpy and volatile overall portfolio returns and distribution of income.

One question I always ask clients is how reliant they are on investment income for meeting their everyday needs and lifestyle preferences. The answer drives the amount of risk they should take and, accordingly, a suitable asset allocation for their portfolios.

The risk of being overly exposed to equity assets is that, in times of market stress, you may need to draw more income and this could decrease the longevity of your portfolio.

Given your age, attitude to investment risk, investment experience and overall objective of producing a consistent income stream, a multi-asset allocation of approximately 65 per cent in equities and 35 per cent in lower risk fixed income investments could be appropriate.

You could take tactical stances on core asset classes based on valuations and expectations for markets going forward. For example, our current biggest underweights are equities and government bonds due to their high valuations in an unfavourable environment. A tactical approach allows us to introduce other asset classes such as infrastructure, property, commodities and private equity to diversify the opportunity set and provide better relative returns.

Given your income requirement, we would select appropriate holdings for the portfolio. For income seeking clients, we look to provide sustainable income growth. We do not believe in chasing the highest-yielding assets, as doing this brings higher levels of risk which may well be unnecessary. Our current income strategy for a multi-asset mandate similar to your risk profile would yield approximately 3.6 per cent, above the yield of your portfolio.

Holding many investment trusts results in an incredibly diversified portfolio yet, as listed assets, trusts can behave like single company equities. So you end up absorbing the additional risk while the return benefits can be somewhat muted, not least because of the fund charges. We would instead take a high conviction direct approach to equities and alternatives to provide exposure via a quality managed portfolio, avoiding the fund charges that this portfolio incurs.

Holdings that feature in both our growth and income strategies include quality businesses such as UK-listed Relx (REL) and Unilever (ULVR), and overseas eqities such as Medtronic (US:MDT), Anheuser Busch InBev (BEL:ABI) and Yum! Brands (US:YUM). For exposure to alternative assets, funds such as Supermarket Income REIT (SUPR) offer quality exposure.

You hold some renewable energy trusts which we also advocate given the long-term growth potential of this sector. 

If sustainable investment is important to you, you could apply your environmental, social and governance (ESG) preferences across your whole portfolio. We accomplish this with an ESG overlay across all portfolio holdings or a fully bespoke ethical portfolio.