Is my retirement dream of £250,000 a year realistic?

Darragh is 56, and married with children aged 17 and 24. He earns £200,000 per year, and his family's home is worth around £3m and mortgage free.

“I would like to retire at age 60 on a gross income of £250,000 per year, which thereafter rises in line with inflation,” says Darragh. “I would also like the value of my investments to grow in line with inflation, say 2 to 3 per cent a year, so that my children can inherit them at the current value. 

"I have taken the 25 per cent tax-free entitlement from my self-invested personal pension (Sipp) and used the money to pay off a mortgage on flats I have given to my children. But I would like to leave the rest of my Sipp to grow. One of my main concerns is inheritance tax (IHT), and the Sipp seems a relatively tax-efficient way to transfer assets to my children.

"But I have drawn on my investments outside pensions holdings to supplement my income.

"I have been investing for about 10 years, although I no longer make pensions contributions as I have hit my lifetime allowance of £1.5m. My wife and I use our full individual savings account (Isa) allowances each year, and contribute to our children’s Isas.

"I’m not looking for high growth given my need to draw income when I retire. I am also relatively cautious and would not want to see the value of my investments decline by more than 25 per cent in any one year.

"I aim to invest about 80 per cent of my Sipp in equity investments as it has an investment horizon of 30 years-plus. I have recently reallocated some of the remainder from bonds into real asset listed funds, which now account for about 15 per cent of it. Bonds account for about 5 per cent. As interest rates are very low, bonds have one way to go and as my holdings in that area mature the income is likely to fall a lot. Also, with the risk of inflation real assets seem right. 

"I aim to allocate 62.5 per cent of the investments outside pensions to equities, with 35 per cent in bonds and 2.5 per cent in cash. I have not yet achieved this allocation as I am cautious. 

"I am looking to get exposure to equities in areas I am not very familiar with such as emerging markets, Asia and technology, via active funds. I also invest in exchange traded funds (ETFs) because they are lower cost.

"I want to divest of my direct UK-share holdings and only invest directly in bonds.

I think that I place too much emphasis on dividends when selecting equities and have too much of a home bias. Although I have expanded the geographic spread of my investments, I am probably underweight the US because I have been cautious on this area and technology stocks due to the risk of regulation. That said, the consequences of the Covid-19 pandemic have made me appreciate the defensive nature of big tech. So I am looking to get exposure to the US and tech via global equities funds.

"I also wondered whether to get professional help to manage my portfolio, as it is quite large. However, I am wary of the extra fees this will incur because these reduce performance over time, and I am not sure how to go about choosing a wealth manager."

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

INCOME STRATEGY

Chris Dillow, Investors Chronicle's economist, says:

I fear you will fall short of your objective of taking £250,000 a year from your investments while maintaining their real value. At current levels, this would require a total real return of 3.8 per cent per year. That might be possible for an equities-only portfolio, but one-third of your portfolio is in bonds, from which you will see very little income after your current holdings mature. If you reinvest in other bonds it is likely that they will have negative real yields.

However, you have four years before you need to take an income. A little capital growth and extra savings should get you nearer to your target. And it’s possible that if futures markets are right, interest rates will rise slightly before you retire, resulting in better returns on safe assets.

But you still face the problem of how to get an income when real returns on cash and bonds are negative.

You can’t solve this problem by holding gold or foreign currency. Although these are good at protecting portfolios from equity bear markets, like cash and bonds, they do this at the cost of negative expected real returns.

And you can't rely on getting extra income by tilting your portfolio towards income stocks. This year’s dividend cuts by banks and oil majors reiterate a longstanding fact: high income is the counterpart of high risk – very often of extra exposure to recession. The cyclical risk of high yielders might pay off over the next few years if the economy recovers. But this isn’t something to rely on for the long term.

I don't think that you need to outsource the management of your investments if you enjoy investing and can’t find a portfolio manager you trust. It’s not at all clear to me that these can do anything you can’t, but they will rack up with extra fees.

James Norrington, specialist writer at Investors Chronicle, says:

The challenge here is meeting a very hefty annual income requirement. So, with your mortgage paid off, homes already given to children and more than enough salaried income to pay your youngest through university before you retire, why do you need a retirement income of at least £250,000 every year?

How you live your life and spend your money is none of our business, but in terms of managing risk in retirement it’s worth thinking along these lines. Your portfolio generated nearly £220,000 of income in 2020, in what has been a terrible year for income investors, so you’ve done well. But you need to consider the risks of chasing an ever-progressing yield when you’re retired. When you’re not working, it may be prudent to take accept less from your investments in some years.

In terms of adding new sources of potential income to the portfolio, consider continuing your rotation away from the UK. This could involve buying growth stocks and creating your own dividends by realising gains during growth spells, but not selling and crystallising losses in a downturn. This is another reason why it is important to consider taking more money in some years and less in others.

Part of this will entail some tax planning. Changes to capital gains tax rules are likely to affect you, so you should speak to a tax adviser about this and making your portfolio as IHT efficient as possible.

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

You could try to improve your long-term risk adjusted returns by implementing the tactical asset allocation approach advocated by Meb Faber of Cambria Investment Management. He suggests selling equities when their price falls below their 10-month or 200-day moving average, and buying them when their price rises above it. This has worked especially well with more sentiment-driven assets such as emerging markets or Aim shares, because these are more prone to momentum. Such an approach works because it gets you out of protracted bear markets of the sort that really destroy wealth.

Applying this rule should improve long-run returns on equities and make it a little easier to draw down wealth by taking an income.

I share your scepticism about big tech in the US. These companies might run into regulatory problems although we cannot predict when. And I’m not sure how defensive they are. They did fantastically well during this year’s equity falls, but this is because they are great plays on the trend for increased working from home. Whether they are defensive with respect to more normal bear markets is questionable.

James Norrington says:

This is a thoughtfully constructed portfolio which takes a holistic approach to wealth. The property and infrastructure investments diversify the risk of your income sources. The bonds and income stocks are all sterling payers, which make sense if you’re retiring in the UK. And you balance this geographic and style exposure with some more growth-oriented plays in the US and Asia.

The UK shares you have chosen to divest show that you are conscious of some of the secular issues facing these companies. For example, divesting from big oil is a popular move due to environmental, social and governance investing becoming more prominent. And even if the days of oil majors such as Royal Dutch Shell (RDSB) are not numbered, the capital expenditure requirements of a fundamental business rethink must surely compete with the need to reward shareholders with dividends and buybacks in the short term. Cutting its dividend at the height of the coronavirus was probably a monkey off Royal Dutch Shell’s back, and it may adopt a more conditional approach to paying dividends going forwards.

Banks are also cyclical businesses, although HSBC (HSBA), which has exposure to Asian growth, looks like it might have more scope to increase its dividend in future years.

That said, targeting income from banks via fixed income securities such as bonds and preference shares looks sensible. After being under scrutiny for a decade following the global financial crisis, banks were well capitalised going into the Covid-19 lockdown. And while dividends on ordinary shares can be cut, bond coupons are an obligation.