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An overfunded pension problem

A tax bill seems inevitable for our reader but there are steps to take to help his situation
October 26, 2017Paul Derrien and James Norrington

Miles Thomas is a 55-year-old dentist. He and his wife, who is the manager of his dental practice, own their home which is mortgage free and worth about £950,000, and his surgery which is worth about £275,000. They also have a buy-to-let property held in his wife's name which generates an income of £1,200 a month and is worth about £650,000.

Reader Portfolio
Miles Thomas 55
Description

Sipps, Isas and property

Objectives

Minimise tax on pension, get income stream from portfolio

Portfolio type
Managing tax

"I have been investing since my first year of employment 30 years ago, but for decades I have injected as much as I could into my self-invested personal pension (Sipp), so it is now grossly over-funded with a value of approximately £2.5m," says Miles. "I had the presence of mind to get a certificate for fixed protection at £1.8m in 2012 when the pension was valued at approximately £1m, but I now need some suggestions on how to minimise tax on the over-funding.

"I would also like some suggestions on how to create an income stream from my investments, as this is uncharted territory for me. I have been comfortable building up wealth by investing in the stock market over the years but I am unsure on how to take it from here as I am considering retiring in the next five years.

"My wife also has a Sipp which is worth about £625,000, and we have individual savings accounts (Isas) worth £313,747 and £106,000 respectively which we self manage."

Miles and his wife's portfolio

HoldingValue (£) % of portfolio
KAZ Minerals (KAZ)166,941.014.73
Ferrexpo (FXPO)108,733.943.08
Dechra Pharmaceuticals (DPH)23,086.600.65
Persimmon (PSN)151,905.604.3
CVS Group (CVSG)229,568.946.5
Mondi (MNDI)97,337.382.76
Restore (RST)178,827.845.07
HSBC (HSBA)182,660.575.17
Taylor Wimpey (TW.)54,113.321.53
Fresnillo (FRES)131,727.373.73
Breedon (BREE)67,647.271.92
Kingspan (KGP)229,358.126.5
Rio Tinto (RIO)288,928.088.19
Ashtead (AHT)141,088.084
BP (BP.)129,408.963.67
Renew (RNWH)123,245.933.49
Compass (CPG)96,767.232.74
Ferguson (FERG)137,310.083.89
Unite (UTG)39,226.931.11
Royal Dutch Shell (RDSB)38,956.861.1
NMC Health (NMC)119,014.203.37
Avon Rubber (AVON)132,534.003.75
Glencore (GLEN)176,605.225
Melrose Industries (MRO)76,206.522.16
BAE Systems (BA.)54,837.751.55
Randgold Resources (RRS)128,084.003.63
Anglo American (AAL)48,571.221.38
Lloyds Banking (LLOY)61,891.451.75
Vedanta Resources (VED)115,257.033.27
Total3,529,841.5 

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

THE BIG PICTURE

Chris Dillow, Investors Chronicle's economist, says:

You are taking lots of cyclical risk. A global economic downturn and fall in commodities prices would very likely see big losses on the large number of commodity stocks you hold, such as Rio Tinto (RIO), Glencore (GLEN) and Randgold Resources (RRS).

It’s been sensible for you to take this risk. I don't say this simply because it has paid off wonderfully well in recent months, with many of your holdings also benefiting from momentum effects. It's because being a dentist is a relatively safe job. Your labour income has therefore been like the interest on a safe bond. And if you've got a big investment in bonds, you can afford to take on cyclical risk because you've got a big cushion to fall back on. We should think of our human capital – our ability to earn a living – as an investment. For those in risky occupations it is like an equity, but for those in safer ones it is like a bond.

But things are changing. As you approach retirement, the value of that bond declines so this argues for taking a safer equity strategy.

Cyclical risk also doesn't pay off forever – that's why it's called cyclical. And we have a small clue that it might turn against us in the coming months: the recent slowdown in China's monetary growth warns us that commodity prices and hence commodity stocks might falter soon. Such stocks might also suffer if the pound rises, as is possible if Brexit uncertainty is offset by the currency's cheapness.

But this is no reason to panic. The slowdown has so far been relatively modest and European growth, at least, looks like it will hold up for a while. And momentum is still on the side of mining stocks. So for now we have a cloud on the horizon rather than an impending storm.

Paul Derrien, investment director at Canaccord Genuity Wealth Management, says:

You should be commended on the investment performance you have achieved over the years and as you approach retirement, despite only being 55, you are right to plan early.

Markets have been strong and you have been handsomely rewarded since 2012 so it is a sensible time to reduce your overall downside risk. This would mean that when you retire you would be able to generate the level of income you want without taking undue risk.

The tax implications of the over funded pension are difficult to avoid. You will be liable to a Lifetime Allowance charge of either 55 per cent on the excess of your fixed protection if you decide to withdraw the excess in one lump sum, or you can elect to pay a one off 25 per cent charge on the excess and then draw a taxable income from the fund. There may be ways of limiting this charge by withdrawing your tax free cash allowance, but there are lots of variables to take into account before you make any decisions on taking distributions from pensions.

As a priority, you should seek expert advice from a financial planner who would build up a complete picture of your circumstances and objectives, and then guide you through the options.

James Norrington, specialist writer at Investors Chronicle, says:

There isn't much you can do about being over the lifetime allowance. You were right to lock-in your lifetime transfer but additionally, you could have done the same for your wife and given her money so she could also have invested a full annual allowance into her Sipp, alongside both of you using your full Isa allowance each year. For example, currently she could contribute up to £40,000 grossed up after tax relief as long as net contributions don't exceed annual salary.

There's not much you can do now because if you try and move money out of your Sipp, that will be seen as a benefit crystallisation event and you'll be drawing down your lifetime allowance, with the excess taxable at 55 per cent.

Going forward, the best thing to do is ensure that you and your wife use up your full annual Isa allowance, which is currently £20,000. Any excess that you wish to invest could be put into tax-efficient vehicles like enterprise investment schemes (EIS) and venture capital trusts (VCTs). These are very high risk but have capital gains and inheritance tax benefits.

Regarding the money in your Sipp, it is better to have 45 per cent of what's left over £1.8m than nothing over £1.8m. You are in a very fortunate position, being asset rich with your retirement needs sorted. So you might as well treat the £700,000 over the limit as 'fun money'. You've already lost at least £385,000 of it to the tax man, so if you're prepared to risk the other £315,000 on risky stocks you could have some fun speculating in the knowledge that overall any losses are 55 per cent on the government! Your portfolio shows a bit of a propensity to play the market with riskier stocks like KAZ Minerals (KAZ), so you could have some fun.

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

You should think about scaling back your cyclical risk. I'm not sure it makes sense to hold cash in a Sipp, as you can usually get better rates elsewhere. But you might think about rotating into more defensive stocks. The virtue of these isn't simply that they hold up relatively well if the market falls, but rather that they offer better long-term average returns than they should.

As for how to take an income stream while minimising tax, it's difficult to give advice as so much depends upon your personal circumstances, for example, do you want to leave a big bequest and how much do you want an immediate lump sum?

What I would warn against, however, is having the tail wag the dog. Many investors wanting an income think they need to buy higher-yielding stocks. This is not the case. You can create your own income from capital gains. Drawdown schemes – which you should consider – in effect do this.

It's true that some income stocks are attractive because a high yield is a sign that investors are under-rating their growth potential – this has been the case for many defensives. But in some other cases a yield is only a reward for risks that might not now be worth taking.

Paul Derrien says:

Over 30 years you will have seen some dramatic swings in the value of your investments so you should understand risk. With 100 per cent invested in equities, with the exception of your properties, the portfolio is very risky. For example, the value of shares could fall significantly. Reducing this risk is paramount.

You need to decide how much income you need in retirement and out of that, how much will need to come from the pensions and Isas. A 3 per cent distribution from the portfolio will currently be over £100,000. So it should be possible to achieve a return that enables a sensible distribution from the Sipps as well as keeping the assets growing in line with, or above, inflation without taking any unnecessary risk.

For example, a portfolio 50 per cent in equities, and 50 per cent in cash, fixed income, and alternatives with low correlations to equities or fixed income, would be sensible. But getting value from fixed income can be a challenge so we currently favour bond funds with the ability to be strategic such as GAM Star Credit Opportunities (IE00B54L8Q54) which has a yield over 4 per cent.

We would also suggest some investments with low correlations to fixed income and equity, for example, The Renewables Infrastructure Group (TRIG), or absolute return strategies such as Legg Mason Western Asset Macro Opportunities Bond (IE00BHBFD929) and Henderson UK Absolute Return (GB00B5KKCX12).

You would still have significant exposure to equities and be able to continue your successful stock picking. Doing this would also reduce the largest equity holdings to 2.5 per cent of the total portfolio, which would significantly reduce the stock specific risk. You have a good spread and balance of equities too, though perhaps a slight overweight to resources, metals and mining that I would top slice from time to time to avoid getting over large.

James Norrington says:

You could try and balance this portfolio so that more of the equity risk is taken with the money you’ve already earmarked as lost to the government. As you have no mortgage, a buy-to-let income also free of mortgage costs and your married couple's state pension, you probably have more capacity than most people to stay invested and just draw an income from stocks in a downturn. 

Unlike an annuity, there is investment risk when taking flexible drawdown from a Sipp. So with money that falls within your lifetime allowance you may want to rebalance towards less volatile stocks, and consider some more fixed income investments such as infrastructure or bond funds. But you don't want to be over exposed to either of these asset classes because infrastructure has liquidity and political risks, and many types of bonds are expensive and their prices will fall if interest rates rise.

However, a well-managed strategic bond fund with a relatively short average duration – sensitivity to interest rates – would provide diversification and give you a more certain income stream in retirement than relying on stock dividends alone.