How can we build up a £100,000 fund for health and care costs?

John is age 73 and his wife is 75. He gets state pension income of £7,800, and income from former workplace pensions of £63,900 and an annuity of £8,300 a year. His wife receives a state pension of £13,200, and £2,600 a year from each of a former workplace pension and an annuity.

Their home is worth about £2.5m and mortgage free.

"My wife has mobility problems and other health issues which are likely to need surgery, but we no longer feel confident that the NHS will provide this when needed," says John. "We used to have health insurance but at our age the premiums are very expensive. So we are building up a fund worth about £100,000 in case we have to go private and to help pay for aftercare. So far, we have put about £60,000 into NS&I Premium Bonds which we have funded with annual withdrawals of around £10,000 after-tax from my self invested personal pension (Sipp). The Sipp is likely to be exhausted in five years, but we should reach this target.

"If my wife needs surgery before then we will need to replenish this fund so need income from our individual savings accounts (Isas) when the Sipp is used up. We would like to grow our Isa portfolios by a sufficient amount so that from 2027, we can take £15,000 a year from them while broadly maintaining their capital value. Our portfolios produced income in the last financial year of around £9,000 which we reinvested because our pensions cover our day to day living costs and most of them have a degree of inflation protection. And when one of us dies, most of the pensions can be inherited by the surviving spouse, albeit at a reduced rate. The surviving spouse is also likely to downsize our home and release capital earmarked for our children.

"I have been investing for 20 years and the longer I've invested, the greater my risk appetite has become. For example, our Isas' value has gone down more than 10 per cent at points this year but we've not been tempted to bail out. And although I am tempted to sell our holding in Fidelity China Special Situations (FCSS), which has halved in value, as it's no longer worth much I might as well hang on.

"The bond funds, meanwhile, have fallen around 30 per cent and this is a problem. I bought them for stability and predictability, and thought that because they are inflation-linked, their value would be protected – even in inflationary times. So should we sell these and take the considerable loss or hang on? Would a well run, slightly dull investment trust like City of London Investment Trust (CTY) be a better source of steady predictability than bonds? As we get closer to the point where we'll be drawing income I'm thinking more about yield, and recently bought Aviva (AV.), Legal & General (LGEN) and M&G (MNG) because they had yields of about 7 per cent.

"I'm also not sure what to do about cash building up. I think our portfolios are a bit of a mess with the initial clarity definitely looking blurred. And we probably need a different strategy, given our desire to start taking income in five years and manage inflation.

"We've already sold shares to help our children financially and pay for work on our house. And I've occasionally taken profits on investments when their prices seemed over inflated. For example, I reduced our holding in Scottish Mortgage Investment Trust (SMT) when it had increased in value by more than 130 per cent – I sold enough shares to cover the initial cost and reinvested the proceeds elsewhere.

"I used to buy and hold exchange traded funds (ETFs) and investment trusts which provided exposure to a wide range of asset classes, sectors, geographies and company sizes. I reinvested income and traded as little as possible and, on the whole, it worked well. But I have also made some opportunistic investments, for example, direct share holdings in Barclays (BARC), Lloyds Banking (LLOY) and NatWest (NWG) as I thought banks would do well as interest rates rose in inflationary times. And I am now thinking of investing in an S&P 500 tracker fund, if the price falls enough for it to be on a reasonable price-earnings ratio."

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

William Amps, wealth management consultant at Mattioli Woods, says:

It's excellent that you have been using tax-efficient Isas and pensions, and achieving long-term growth by investing. But some straightforward planning could also help to achieve your financial goals.

It is essential to consider your objectives and their respective priorities. You should first consider your ability to meet day-to-day expenses so it is pleasing that this is fully met by your various guaranteed sources of income. This frees the entirety of your savings for future capital expenses such as private medical bills and care costs, for which you aim to build a fund worth £100,000 and recurring tax-free income of £15,000 a year.

Based on an assumed annual growth rate of 4 per cent, the total value of your Isas can be forecasted to be worth approximately £500,000 by 2027. This is a sufficient size to sustain annual withdrawals of £15,000 a year while broadly maintaining the value of the Isas. But investment returns are not guaranteed and can fall as well as rise.

I agree with your original strategy of diversifying across a wide range of asset classes, sectors, geographies and company sizes. But your trades over the years have distorted your sector and asset allocations, somewhat.

The defensive cash and fixed interest holdings make up approximately 28 per cent of your invested assets and the remainder is primarily equities. This asset split is broadly in line with your attitude to risk. You also have the capacity for short-term volatility because your income is met by guaranteed sources and you are holding your health fund in government backed NS&I Premium Bonds.

Your Isas seem overweight in financial services and the UK economy, and lack exposure to property, though the holdings you have chosen are reputable and have positive long-term records.

A rebalancing exercise is an easy way to achieve effective diversification. Bond holdings are included in portfolios as a defensive asset class because they are typically less volatile than other assets. This has not been the case over the past year due to economic conditions. But fixed interest investment continues to have a place in portfolios as a source of diversification to help reduce overall volatility and risk.

Also consider using Isa assets to build your health fund as opposed to your Sipp, given the beneficial inheritance tax treatment of pensions. Pension funds do not form part of your taxable estate but the assets in your Isas do. And doing this would reduce your income tax liability in the short-term as higher-rate tax is being applied to your pension income.  

James Norrington, associate editor at Investors Chronicle, says:

You’re doing many things correctly and your planning is spot on. It's sensible to hold your contingency fund in a low-risk asset such as NS&I Premium Bonds. And with no mortgage and a steady income from workplace and state pensions, you aren’t exceeding your capacity for investment risk. 

The issues you mention have affected many investors in 2022. Index-linked gilts have sold off with other government bonds because of their duration risk. When inflation goes up, the coupon on the bonds may rise but the price must still fall for the bond yield to match the market rates of interest that investors require. Index-linked bonds tend to be quite long in duration which means that their prices are sensitive to rates and therefore prone to capital losses in a hiking cycle as we have seen.

Your Sipp portfolio is sound. There is an argument for getting your government bond exposure from shorter duration gilts especially now that interest rates are higher. That said, there will probably be a recession by this time next year when the rate tightening will abate, and your capital losses from 2022 could start to reverse. At that point, your longer duration play with a bit of inflation protection built in should feel like a much wiser move.

However, as you add to the Isa portfolios think about diversifying the fixed income allocation. Investment grade corporate bonds with a shorter duration are an asset class where there is some value. Their spreads over government bonds should offer an attractive income and, unlike dividends which can be cut, companies are bound by their obligation to pay lenders. Recession increases default risk but at the higher end of the quality spectrum, ie investment grade credit, the risk-to-reward trade-off is acceptable, especially in a fund.

With the equity investments, don’t fall into the trap of chasing high-yield shares – especially with the world on the precipice of recession. As corporate profits are hit dividends will be in the firing line. Some of today’s high yielders look attractive precisely because the market is sceptical that the pay-out is sustainable.

You’ve gone rather heavily into financial shares which is a bit of a risk, especially as banks could have to make writedowns if many loans and mortgages go bad in a recession. When buying shares for yield, ask yourself what the competing forces for earnings are. Firming up capital reserves will trump distributions to shareholders as things get ugly, and banks also have big expenses due to having to keep pace with new technologies and regulation.

Given your situation, the solid income paying investment trusts you own are sensible. They have in the past shown commitment to paying dividends out of capital reserves if the companies they invest in provide lean pickings in tough times. This is bad in so far as it reduces compounding power, especially for younger investors, but if you want steady cash flows from a trust it could be right for you.

It would be a good idea to sell some of the smaller holdings you don’t plan to top up, although you don’t have to do this in a rush. You are minded to hang onto Fidelity China Special Situations and China is a region which several commentators sound more positive towards again. The shift from a zero-Covid policy could be a catalyst for a recovery in Chinese equities in the second half of 2023. There are still risks meaning that Chinese equities shouldn't account for more than a small proportion of your portfolio, but it's likely that you'll get better opportunities to sell this trust in the future.