'Half our assets are in cash – can we still spend £60,000 a year?'

‘Mr and Mrs A’ are 67 and 61. He currently receives a state pension of £182 a week and Mrs A will qualify for nearly the full state pension in six years. Mr A also earns up to £2,000 a year. And they receive dividends and interest from their investments. Since they retired seven years ago their average total annual income has been around £40,000, most of which comes from dividends from investments in their self-invested personal pensions (Sipps).

Their home is worth about £500,000 and mortgage-free. They also own half of a piece of woodland and two pieces of land, but as they do not yet know whether they will get planning permission to build on the land parcels, their value is unclear.

“We featured in the Investors' Chronicle Portfolio Clinic in 2015 (‘Is a 50:50 cash and equity split right’, IC, 22 October 2015) just before we sold our business and retired," says Mr A. "The sale of the business increased the value of our portfolio to around £2.2mn, since when we have renovated and moved into a larger home.

“Our average annual outgoings have been £66,000, with essential spending accounting for around £50,000 of this. I maintain simple annual spreadsheet accounts of our spending, record our annual income and regularly update a spreadsheet with our estimated net worth, to construct cash flow forecasts. But we are not sure whether an inflation-adjusted, after-tax income of around £60,000 a year is sustainable. 

“We are in generally good health and don't have children so are happy to spend capital and possibly downsize our home in later years when it may be too large a responsibility. We don't want to leave any legacies, although have wills and Legal Power of Attorneys in place.

“We have not accessed our Sipps, other than taking the dividends, and drawn from other accounts to fund outgoings, car replacements, holidays and property renovations. As our cars are relatively new and our property shouldn't require further spending for a number of years, we shouldn't have any major outgoings at least until I am age 70. We have not incurred any income tax in the past seven years, but I may start to owe some from April so will seek to mitigate this.

“I thought of starting to draw from both our Sipps from the time I am age 70, but am not sure whether to do this initially as uncrystallised funds pension lump sums (UFPLS) or by taking the 25 per cent tax-free lump sums. I would like to just draw the natural yield of our investments and not sell chunks of capital until later in our lives. And I would like to retain a reasonable amount of capital outside the pensions to fund large purchases and holidays.

“Nearly half of our assets, excluding our home, are in cash. I had a high risk tolerance, but the Covid-19 pandemic, Ukraine invasion, gloomy economic outlook and our increasing ages have tempered this and caused me to once again hold nearly half of our portfolio in cash. Protecting our assets is of paramount importance, but high inflation means that we need to balance the risk of investment losses against having a large cash allocation, the value of which gets eroded. In particular, we need to consider how much of the £431,000 cash in our Sipps we invest and in what, as we do not get a decent interest rate on this.

"Since 2015, I have radically altered the contents of our Sipps, individual savings accounts (Isas) and general investment accounts. I treat our assets as one portfolio, and have allocated away from equities and bonds in favour of other income-producing assets. Recent investments include topping up existing positions by reinvesting monthly dividends.

"Outside the Sipps, we keep cash worth three to four years of our expenditure in easy and short-term restricted access accounts, and Isas. We also have index-linked NS&I products and Premium Bonds.

"I have moved out of open-ended funds into investment trusts and exchange-traded funds (ETFs) because they are cheaper to hold on the investment platform we use."

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

Dennis Hall, chartered financial planner at Yellowtail Financial Planning, says:

When reviewing a portfolio, I often find it difficult to discern the overarching investment strategy. But not this time. Ignoring the high levels of cash, it has a strong bias to income and dividend yield. However, it often seems to be at the expense of capital growth. Some of the higher dividend paying funds have had relatively flat performance or even a capital loss over the past five years.

Going overweight in higher dividend stocks means focusing on a relatively narrow part of the market and missing out on growth companies which have done well over the past decade. You have some diversification in other sectors such as property and physical gold, and Scottish Mortgage Investment Trust (SMT), though again these are focused investments and they haven't all worked out. But I am pleased to see Vanguard FTSE All-World UCITS ETF (VWRL) as I believe that this or something similar should form the core of many portfolios. Its dividend is low compared to many other holdings in the portfolio, but if investing on a total return basis some capital growth in good years is used to top up the income drawdown pot. 

I have run some back test simulations for a fully index-linked income of £60,000 net a year from the combined portfolio. With a cash/equity split of approximately 50/50 the probability of the portfolio outlasting either of you is not high enough to give any real comfort. The simulations use actual data for global equity and bond returns alongside UK inflation since 1915.

Shifting the equity content higher - I use global equities and a market capitalisation weight basis - significantly improves the probability of success. Overall, something in the order of 80 per cent equities and 20 per cent cash or near cash appears to provide the right balance between sustainable portfolio returns and risk. I consider risk to be the permanent loss of capital - not market volatility. 

I wouldn't hold much cash in the Sipp because you can obtain better rates of interest outside. In a combined portfolio of £2mn the cash element should be nearer to £400,000 which would provide access to income for several years if the equity element suffered a severe crash. However, in good years the growth would replenish the cash pool. This doesn’t require a focus on generating high dividends and would allow much greater diversification in the equity holdings. My suggestion for something to invest the existing Sipp cash in is something like Vanguard FTSE All-World UCITS ETF.

When accessing the Sipp, I would do it via a combination of tax-free cash and flexible income drawdown to maximise tax efficiency by keeping the taxable income component within the lowest tax bands. I would decide which funds to sell on an annual basis depending on how markets have performed. In years that there is a loss I would dip into the cash instead.

Over time I would seek to simplify the portfolio, not least because as we age our cognitive ability declines. And if anything happens to the spouse who is currently managing everything, it becomes easier for the surviving spouse to manage.

Michael Lapham, director at Mercer & Hole, says:

Basic cash flow models suggest that an inflation-linked income of £60,000 a year should be sustainable until you are into your 90s, even if your investments achieve very little net growth. So from this perspective, you should not need to invest the cash in your pension funds. Your current equity holdings should provide enough growth to balance out the lack of returns from cash. But if you want to invest this cash, we suggest buying income units of income-yielding funds, which will add to the cash available for withdrawals.

Drawing from assets tax-efficiently is an important way to provide lifetime income. All available tax allowances should be used to make income provision sustainable  Avoid creating tax liabilities for as long as possible. 

So we suggest that Mrs A starts to draw pension income now to use her personal allowance for income tax. Assuming that she has no other taxable pension income, she could draw potentially taxable pension income of £12,570 each year without creating a tax liability. She could draw £16,760 via UFPLS each year, £4,190 of which would be a tax-free cash sum and £12,570 potentially taxable, but not taxed as it does not exceed her personal allowance. You lose your personal allowance if you do not use it each year and forego the opportunity to withdraw monies tax-free from your pension.

Mrs A should continue to do this until her state pension comes into payment and then reduce the annual withdrawal to a size that just uses up any personal allowance not used by her state pension. Mr A should consider doing likewise to use any of his annual personal allowance that is left.

The capital you draw from your pensions could come from the existing cash in your Sipps or the yield produced by the funds for a number of years, meaning that you do not have to sell any assets.

The remainder of your current income needs should firstly be met with cash held outside pensions. When this is exhausted, we suggest drawing from your Isas, which is tax-free, and taking the tax-free cash from your pensions via income drawdown each year. You could take the income yield generated in your Isas and Sipps to avoid selling assets. This is more prudent than taking all your pension tax-free cash in one go as you draw each year's yield rather than sell assets in one go. 

When you have exhausted these tax-free income sources, take taxable income from the Sipp via flexi-access drawdown each year. The withdrawals should be split between your Sipps to keep your taxable incomes within the basic rate tax band.