How can I best complement my annuity income?

Paul is 69 and retired. He receives around £35,000 a year from annuities, while he and his wife get a combined £20,000 a year from the state pension. The couple has land worth £200,000, and a property worth £2mn with a £250,000 equity-release mortgage. Paul has around £500,000 and his wife has £32,000 in self-invested personal pensions (Sipp).

He now wants to get more out of his portfolio. “I would like £12,000 a year to complement my state pension and annuity income, and ideally as much as £20,000 as fun money,” he says. “I want to achieve growth after extracting 5 per cent or more per year, so ideally would like to see a 10 per cent return year in, year out.”

Paul sold a chunk of his investments earlier this year, and now has around £190,000 in cash within the Sipp. However, he is unsure whether to reinvest it now or hold out for another fall in markets.

“I sold 35 per cent and went into cash in July 2022,” he says. “The key question now is whether to reinvest or wait for a downturn.”

In terms of his investment approach, Paul tends to have a 50/50 split between active funds and trackers. He avoids what he notes are “high-risk” investments, including bitcoin and emerging market equities, and has found himself investing more outside the UK over time due to concerns about Brexit. He picks funds rather than stocks, and believes the “low-risk stability” of his annuity and state pension income allows him to focus on equity exposure within the Sipp.

When it comes to risk appetite, Paul notes that he “could lose 50 per cent and survive, although would prefer not to lose more than 10 to 15 per cent in any given year”.

He also wonders whether he can improve the geographical mix of the portfolio, and whether to have proportionally more in the US. He lowered his UK allocation from 40 to 10 per cent of the portfolio three years ago, and his Asian exposure from 20 to 10 per cent last year due to some erratic performance, and has been putting more money into US funds because of their strong returns and dollar strength. The portfolio has had relatively strong performance in 2019, 2020 and 2021, but has suffered a fall of around 10 per cent so far this year.

Outside the Sipp, Paul has £30,000 as a cash reserve from the equity-release mortgage and £40,000 in his management consultancy business, which can be drawn in a tax-efficient manner over the next few years.

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

John Moore, investment manager at Brewin Dolphin, says:

I would separate the two requirements: £12,000 coming from natural income and the £20,000 coming from (hopefully in time) capital gains or bond maturities, or some balance of the above. 

I do think some balance would be helpful not only in the personal circumstances outlined, but also looking forward in terms of inflation and volatility, which are likely to be more persistent than many of us would want. So, I would propose looking at allocations in the bond and alternatives areas.

One of the positives from the inflation and interest rate sell-off is that many gilts and bonds trade below their repayment value, providing a natural upside, should you be worried about the short-term limit to the immediate downside. You could buy the following:

• 1% Treasury 2024
• 2% Treasury 2025
• 0.375% Treasury 2026
• 1.25% Treasury 2027

For an average of 93.75p in the £1, you will be repaid and, in addition to that, capital uplift generates an income of 1.2 per cent – a rate ahead of what most high-street banks will offer in interest for accessible cash. The gilts with the shorter maturity dates could provide a source of capital to satisfy the £20,000 fun money. This could also, by association, leave the equity exposure for longer (should recovery be required) or indeed if the momentum is such that you do not want to disturb it. Alternatively, this could also provide the firepower to reinvest should those opportunities arise.  

You might add additional exposure to broaden things out with US treasury inflation-protected securities (TIPS) tracker funds and global investment grade credit.

Moving on to alternatives, there are three buckets worthy of consideration: infrastructure, property and absolute return. In the infrastructure area there are plenty of choices, and these include HICL Infrastructure (HICL) and Greencoat UK Wind (UKW).

HICL has a range of assets from public-private partnerships/private finance initiatives to digital infrastructure and electricity transmission connectors. The company is also building up geographic diversification, which is in line with the essence of what I believe you are aiming to achieve.

HICL offers a yield of around 4.75 per cent, and there are prospects for this to increase in time. Helpfully, the correlation to equities is low.

Greencoat UK Wind is one of the largest independent owners of windfarms in the UK, and has a mixture of contracted and wholesale income, the latter offering variability that can be some form of hedge against rising electricity prices. The yield on Greencoat is a little lower at 4.6 per cent, but the trust has been reinvesting its excess income in additional assets, which offers potential for income growth in time.

Property has historically been a source of inflation protection, and I believe that the relevance of this remains due to replacement cost/newbuild cost offering pricing power, though there are challenges such as a possible recession. The likes of abrdn Property Income Trust (API) offer bricks-and-mortar exposure throughout the UK with a bias to industrial assets and some interesting environmental, social and governance potential.

TR Property (TRY) owns property shares and some physical property. Holding the former often leads to more volatility in the short term, but in time returns tend to correlate more with physical property, and there have been periods of meaningful outperformance. TR Property has a highly experienced management team and flexible mandate, which feel valuable at this point and, although it is more capital growth focused, the yield of over 4 per cent is helpful. 

In terms of absolute return, Capital Gearing (CGT) and Personal Assets Trust (PNL) offer experienced management teams, diverse underlying exposure and lower than average volatility and correlation to markets over time. Both offer a yield of around 1 per cent, which helps with the natural income achievement.

I would retain around £35,000 to £40,000 in cash to cover the immediate income and fun times requirements until the 2024 gilt matures. 

Michael Lapham, director of financial planning at Mercer & Hole, says:

We would use lifetime cash flow modelling to determine the level of lifetime income sustainable from an investment portfolio. We feel that using cash flow modelling is more accurate as it takes into account longevity and taxation. It is very important to take tax into account as it is a net level of income that needs to be provided. We generally assume survival to age 90 to allow for longer-than-expected mortality.      

We would always consider inflation when considering the level of income that a portfolio would support as the price of things you spend money on will increase. 

You said that you would prefer not to lose more than 10 to 15 per cent in any given year. On this basis, we would suggest that the 35 per cent you hold as cash not be invested in further equities, but that you hold more of a 'balanced' portfolio. We might assume such a portfolio will produce a net long-term average annual return of 4.5 per cent.

Based on our assumptions, if your portfolio was fully invested, an additional £32,000 of inflation-linked annual income would not be sustainable for the remainder of your lifetime, assuming any reasonable rate of fund growth. We have calculated that the maximum sustainable level of additional annual income is £20,000 a year. 

Therefore, an additional £12,000 a year to cover day-to-day bills should be eminently sustainable over your lifetime. You could still draw a further £8,000 a year for “fun”. In any case, you might find that your need for fun money diminishes as you get older, so maybe you will not need the full £32,000 a year for the remainder of your lifetime anyway.

We would expect your current partially invested portfolio to return around 3.5 per cent a year after charges. This should be sufficient to support your basic additional £12,000 income need, but not any fun expenditure.    

We do not have the expertise to call the market and decide when you invest. We believe in time in the market, not market timing. We would therefore suggest that you invest the cash you hold to give it the maximum opportunity to grow, which should mean that you can afford some fun expenditure.