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Take income tax-efficiently and cut your holdings

Our reader should draw income tax-efficiently and cut his holdings
October 30, 2017

Paul is 63 and his wife is 65, and they are both retired. They receive indexed-linked pensions of £25,000 a year plus £5,000 a year from his self-invested personal pension (Sipp), and they both have equity-focused individual savings accounts (Isas). Although their estate is over the inheritance tax (IHT) threshold, they think that with the introduction of the family home allowance this should not be a major issue.

Reader Portfolio
Paul 63
Description

Sipp, Isas, VCTs and cash

Objectives

Supplement pension income

Portfolio type
Managing pension drawdown

"We spend all our income plus a further £5,000 on holidays, taken from our cash holdings or top-slicing of existing investments," says Paul. "This does not concern us because I shall receive a state pension of around of £7,000 a year in two years' time, which will mitigate this.

"I have been taking 5 per cent a year from my Sipp for four years, over which time its capital value has still appreciated by 10 per cent. This may not continue, but I always try to hold at least one year's income in cash within the Sipp in case there is a serious market correction. Our high cash reserve allows us to sleep at night and falls in the market do not greatly concern us because we are invested for the long term. And I may use the Sipp to buy an annuity if and when I can get a rate of 7 per cent.

"However, I wondered what I should do with my euro-denominated bank account held in Spain, which is worth around £65,000, and the UK bank accounts? 

"Our direct bond holdings were purchased at par or below and I intend to keep them until maturity as I cannot see interest rates reaching such high levels in the foreseeable future. I had a bond issued by Provident Financial (PFG) which matured this year so I am looking for a replacement.

"I have gradually been selling funds and direct shareholdings, replacing them with passive tracker funds. But do I still have too many holdings?

"I believe the funds I still hold have a very good chance of beating their benchmarks. And although I am heavily weighted to Barclays (BARC) it is regularly tipped as a buy and hopefully the dividend will gradually get back to its previous level."

 

Paul and his wife's portfolio

HoldingValue (£)% of the portfolio
Aberdeen Global Emerging Markets Smaller Companies (LU0837974368)2903.080.38
Barclays (BARC)3087.750.4
First State Global Resources (GB0033737767)1973.30.26
Hargreaves Lansdown Multi-Manager Asia & Emerging Markets (GB00BSD99P77)6332.340.82
Hargreaves Lansdown Multi-Manager European (GB00BSD99K23)6765.50.88
iShares MSCI Target UK Real Estate UCITS ETF (UKRE)4886.540.64
iShares MSCI World GBP Hedged UCITS ETF (IGWD)5578.440.73
Jupiter European (GB00B5STJW84)7789.631.01
Ladbrokes Group Finance 5.125% STG Bonds 10/09/2022 (LAD2)105251.37
Liontrust Special Situations (GB00B57H4F11)7103.090.93
Newton Global Income (GB00BLG2W887)16751.512.18
Primary Health Properties (PHP)52210.68
Regional REIT (RGL)5070.470.66
SPDR FTSE UK All Share UCITS ETF (FTAL)5853.560.76
Standard Life Investments Global Smaller Companies (GB00BBX46522)8460.961.1
Starwood European Real Estate Finance (SWEF)3247.50.42
Tesco 5.5% NTS 13/01/2033 (31CM)162752.12
Tritax Big Box REIT (BBOX)6515.080.85
Vanguard FTSE 100 UCITS ETF (VUKE)9071.791.18
Vanguard S&P 500 UCITS ETF (VUSA)16386.172.13
Wasps Finance 6.5% STG BDS 13/05/22 (WAS1)48070.63
WisdomTree US SmallCap Dividend UCITS ETF (DESE)5329.260.69
Aberforth Split Level Income Trust (ASIT)12060.681.57
Aviva 6.125% FXD RTE SUB NTS 2036 (AE57)115651.51
CF Woodford Equity Income (GB00BLRZQB71)25045.283.26
CF Woodford Income Focus (GB00BD9X7109)113301.48
db x-trackers FTSE All Share UCITS  ETF (XASX)2467.20.32
Henderson Fixed Interest Monthly Income (GB00B7GSYN71)7130.590.93
Hargreaves Lansdown Multi-Manager Income & Growth Trust (GB0032033127)20,373.562.65
Lloyds Banking (LLOY)5232.120.68
Paragon Banking Group 6% NTS 5/12/20 (PAG1)104951.37
Paragon Banking Group 6% NT Redeem 28/08/2024 (PAG3)104851.37
Royal Mail (RMG)1463.710.19
Aberdeen Property Share (GB00B0XWNN66)5812.930.76
Artemis High Income (GB00B2PLJN71)4096.090.53
Burford Capital 6.5% GTD BDS 19/08/22 (BUR1)5427.50.71
CQS New City High Yield Fund (NCYF)3881.290.51
Invesco Perpetual Distribution (GB00BJ04FJ86)4098.20.53
JPMorgan Japanese Investment Trust (JFJ)3921.170.51
Jupiter Strategic Bond (GB00B544HM32)3779.10.49
M&G Property Portfolio PAIF (GB00B89X8P64)4007.360.52
Newton Real Return (GB00BSPPWT88)4387.870.57
Royal London Sterling Extra Yield Bond (IE00BJBQC361)5045.850.66
Schroder European Equity Absolute Return (GB00B39VWZ39)2390.020.31
Schroder UK Dynamic Smaller Companies (GB0007220360)6195.70.81
Standard Life GARS (GB00B7K3T226)4472.460.58
Stewart Investors Asia Pacific Leaders (GB0033874768)6020.930.78
Trojan Income (GB00B01BNW49)5037.630.66
Unicorn UK Income (GB00B00Z1R87)4665.770.61
Vanguard FTSE Developed Europe ex UK Equity Index (GB00B5B71H80)6348.810.83
Vanguard FTSE All-World High Dividend Yield UCITS ETF (VHYL)6641.430.86
Venture capital trusts 120621.57
Cash39194751.04
Total767821.2 

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:

It's reasonable, given your risk aversion, to consider buying an annuity – these give you security, which drawdown does not. In view of this, it's reasonable to have lots of bonds and bond funds, which in effect hedge against annuity rate risk. If bond yields fall, your hopes of getting a nice annuity will recede, but you'll be compensated for this by capital gains on bonds.

I sympathise with you having a high allocation to cash despite low interest rates. Rates are low because both investors and central bankers think the prospects for western economies are weak and risky. This is not an environment in which shares are assured of success, so it's reasonable to have high cash weightings.

What I'm not so sure of is holding euros. These make sense if you're thinking of, for example, buying a holiday home in Europe as they hedge currency risk. And they also offer a hedge against Brexit going even worse than expected and against financial crises, as sterling tends to fall in these circumstances. Such insurance, however, comes at a price: sterling is now cheap in real terms and you might well suffer losses on euros if these risks don't materialise.

If you must hold euros, consider doing so in a Sipp, while holding your sterling cash outside the Sipp. Sterling deposit rates in Sipps are often awful, so you might get better returns elsewhere. But as euro interest rates are nugatory anyway this isn't a consideration with them. 

 

James Baxter, managing partner at Tideway Wealth, says:

I would start with a big picture plan, first considering tax planning and asset allocation, and then investment selection.

Regarding the tax planning, you might want to consider not drawing from your Sipp and letting this grow in value. This is a fund that's outside your estate for inheritance tax (IHT) purposes and could still provide you and your wife with income if it's needed.

By doing this you will make an immediate saving of £1,000 a year in income tax. You could even reverse the cash flow by adding in the £3,600 a year stakeholder contribution to your Sipp and get a further £720 a year back in tax so that you would be £1,720 a year better off overall without any additional risk.

You also need to look at putting as many as possible of the income-generating assets, like the corporate bonds and equity income funds, into your Isa and Sipp, where the payouts would not incur income tax. Investments aiming purely for capital gains, such as smaller companies or emerging market funds, can be held outside tax-efficient wrappers as you and your wife can use your capital gains tax allowances of £11,300 each per year to offset any taxable profits when you sell them.

 

Jason Witcombe, director and certified financial planner at Evolve Financial Planning, says:

When someone needs extra income in retirement it can always be tempting to assume that this should come from their pension rather than, for example, Isas which we often think of as savings. However, given that pensions are very tax-efficient from an estate planning perspective, particularly in the event of death prior to age 75, there is a good argument for some people to draw down on other assets such as cash savings, Isas and any taxable investments, which all form part of your estate from an IHT perspective, rather than from pension funds.

It also depends whether the £5,000 a year you have been drawing relates to your tax-free pension lump sum, which can be drawn over numerous stages rather than all in one go, or whether this is taxable income, netting down to, say, £4,000 a year in your pocket. There are lots of variables in this and your current approach may be perfectly sensible, but you noted IHT as an issue, albeit a minor one.

If you eventually decide to buy an annuity bear in mind that a number of insurers offer medically underwritten annuities, so if either you or your wife has any reason to believe that your life expectancy is lower than average then you may be able to obtain enhanced rates.

 

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

You ask whether you have too many holdings. I suspect the answer is yes, because so many of them are funds.

Many funds have lowish tracking errors, so their chances of deviating a lot from their benchmark are low. This follows from the brute maths of diversification. Because they hold lots of stocks funds reduce idiosyncratic stock risk, but this naturally increases funds' correlation with the market. And if you hold lots of assets with low tracking errors you end up with a portfolio that has a tiny tracking error so that it tracks the market.

And you'll incur asset manager fees which compound horribly so underperform over time. 

You believe your funds have a good chance of beating their benchmarks. Even if this is true, and I'd remind you of the ubiquity of overconfidence, it still means there's a good chance of many underperforming. Let's take a football analogy. Manchester City, the best team in the English Premier League now, has a good chance of beating Spurs, Man United and Arsenal. But the chances of it winning all its remaining games this season are tiny – and it's the same with funds.

A good chance of each winning doesn't mean there's a good chance of every one doing this. We can use a binomial distribution to calculate this. It tells us that even if each of 30 funds has a 60 per cent chance of beating the market, there's a greater than one in six chance of most failing to do so and only a 29 per cent chance of more than 20 doing so.

So I'd consider trimming my fund holdings. Don't just consider a fund's intrinsic merits, but also what it gives you that your other holdings don't.

 

James Baxter says:

It looks as though you are holding too much cash. With inflation running at around 3 per cent, holding cash is a sure-fire way to see its real value depleted over time. Reducing this to, say, 10-15 per cent of your assets overall would still give you five years' income reserves plus an emergency fund.

If you are going to hold funds rather than individual shares, which is best for all but the most committed self-directed investors, then you do have too many holdings. This means you have no meaningful diversification, and if you buy lots of actively managed funds an increasing certainty of underperforming the index.

Given your need for income we would suggest actively managed equity funds rather than index trackers as it's clearer how their managers add value. Unicorn UK Income (GB00B00Z1R87) is a great example of that, but to really benefit from its managers' expertise you need a bigger holding.

It rarely pays to get exposure to fixed income via a tracker fund, and certainly not in current market conditions. Gilt funds, index-tracking gilts and corporate bond funds are sure-fire ways to lose money in real terms over time, just like cash.

You need to focus on higher-yielding funds run by active managers who invest in shorter-dated bonds to protect against rates rising. Moving your individual bond holdings into these funds over time should be a good move, and don't always wait until the bonds mature. Look at the return to maturity based on the coupons still to be earned less the capital drop, as all your bonds are now above par. When this return falls below 3 per cent it will be time to think about switching.

 

Jason Witcombe says:

I completely agree with gradually reducing your direct share and actively managed fund holdings in favour of low-cost tracker funds. Taking Vanguard FTSE Developed World ex-UK Equity Index (GB00B59G4Q73) as an example of an overseas equity tracker fund, this gives diversification across 2,000 stocks worldwide. That is incredible diversification for a 0.15 per cent a year charge. Add in a FTSE All-Share fund at an even lower cost and you have global equity diversification. Low-cost fixed interest and property funds are also available.

Costs can have a significantly detrimental effect on long-term investment returns and higher-cost actively managed funds are on the back foot before they have even started. In many instances you get what you pay for, but with investing it is the opposite. Naturally, some high-cost funds will beat their lower-cost rivals in the long run but, on average, most of them won't and picking tomorrow’s winner in advance is fraught with difficulty.