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Take your pensions tax-efficiently

Our experts advise on the best way to draw a pension lump sum
November 9, 2017, Katharine Lindley, Colin Low and Mike Neumann

Simon is 59 and married with two daughters aged 19 and 23. He plans to retire early next summer from his role as a finance director of a small UK company. He and his wife, who no longer works, jointly own the family home that is valued at about £700,000 and mortgage free. His wife also owns a buy-to-let property worth £300,000 that is let for £900 a month net and is mortgage free.

Reader Portfolio
Simon 59
Description

Isas, trading accounts, property and VCTs

Objectives

Supplement retirement income and help children

Portfolio type
Managing pension drawdown

"I have three defined benefit (DB) pensions from my current and previous employers, as well as a defined contribution (DC) scheme," says Stephen. "My DC pot is valued at around £400,000 and my current employer's DB scheme will pay a pension from age 60 of £36,000 a year. The two smaller DB pensions from previous employers, if taken at 65, would have a combined value of about £15,000 a year.

"I have applied for individual protection to maintain my lifetime allowance limit at £1.25m, although I will still exceed this slightly. So I no longer contribute to my pension – instead I add cash to my regular investments. At retirement I can maximise the tax-free pension commencement lump sum by combining the values of the DB and DC schemes of my current employer. This should enable me to take a pension commencement lump sum of about £280,000.

"My wife has a small personal pension of about £32,000 to which she no longer contributes, but she is entitled to a widow's pension from my DB schemes of just over £30,000 a year. I will be entitled to the full state pension at 66 and my wife, having bought up six years of National Insurance contributions, should be entitled to about 98 per cent of the full state pension at age 67 in 2030.

"I and my wife invest the maximum amount possible each year into our individual savings accounts (Isas), which account for about 75 per cent of our combined portfolio, and add to our holdings and rebalance them via regular monthly investments. 

>The idea that we should own fewer equities as we age is in many cases plain wrong

"The income from the DB schemes and rental income will cover our general expenses, so income from our savings could be used for more extensive travel and additional expenditure. This would probably be higher in the early years but could be controlled to ensure that sufficient funds are maintained in case there is a market downturn. If a significant downturn has a detrimental impact our on savings I could work on a contract or interim basis. There appear to be plenty of opportunities for interim work in finance.

"At retirement we plan to take the maximum tax-free cash available and invest it proportionately in the existing holdings. This will be split between us so we can both benefit from the dividend income tax allowance, and we will then progressively move it into our Isas. 

"I will draw down the remainder of my DC pot, which is worth about £120,000, over the next five years until my other pensions are taken. I plan to do this because I already exceed the pensions lifetime allowance – any growth in the value would be taxed under the Lifetime Allowance Charge. In the meantime it will remain invested in Fidelity Life Balanced Fund.

"We are aiming for our investments to generate a return of 2 per cent above inflation from either income or growth. Our withdrawals will probably exceed the natural yield and growth in the early years as we plan to enjoy an active retirement, and assist our daughters as they finish university and in their early working life. The excess capital in this portfolio will be for my children to inherit so it has quite a long investment horizon. 

"I have a heavier weighting to equities than is generally advised for someone of my age, but I think this is alright because my DB pensions are index-linked. 

"We save into the portfolio via monthly investments. However, the pension commencement lump sum will give us a significant amount to handle. Would you suggest making a one-off investment with it or drip-feeding it in over a year or two? If we were to do the latter in what assets should we hold the money prior to investment?"

Simon and his wife's portfolio
HoldingValue (£)% of portfolio
iShares Core FTSE 100 UCITS ETF (ISF)36,0006
iShares UK Dividend UCITS ETF (IUKD)30,0005
City of London Investment Trust (CTY)24,0004
iShares FTSE 250 UCITS ETF (MIDD)30,0005
CF Woodford Equity Income (GB00BLRZQ737)18,0003
Woodford Patient Capital Trust (WPCT)18,0003
BlackRock Smaller Companies Trust (BRSC18,0003
Direct shares24,0004
iShares S&P 500 UCITS ETF (IUSA)54,0009
iShares Core MSCI Pacific ex-Japan UCITS ETF (CPXJ)30,0005
iShares Euro Dividend UCITS ETF (IDVY)30,0005
Vanguard FTSE Emerging Markets UCITS ETF (VFEM)30,0005
3i (III)24,0004
HICL Infrastructure Company (HICL)36,0006
Real Estate Credit Investments (RECI)36,0006
Primary Health Properties (PHP)36,0006
iShares Core £ Corporate Bond UCITS ETF (SLXX)24,0004
TwentyFour Income Fund (TFIF)24,0004
iShares Core UK Gilts UCITS ETF (IGLT)24,0004
Downing Two VCT (DP2K)3,6000.6
Maven Income & Growth VCT 6 (MIG6)7,2001.2
Octopus Titan VCT (OTV2)10,8001.8
Octopus Aim VCT (OOA)3,6000.6
Octopus Aim VCT 2 (OSEC)3,6000.6
Elderstreet VCT (EDV)7,2001.2
Cash18,0003
Total600,000 

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:

Your target returns are  reasonable: a total real return of over 2 per cent seems modest. If we assume equities are fairly priced, then the dividend yield won't systematically change much. If dividends then grow at the same rate as real gross domestic product (GDP), UK equities should return just over 5 per cent a year in real terms: income of around 3.6 per cent – the current yield on the FTSE All-Share index – and capital growth of around 1.5 per cent. There will be volatility around this but with average luck there should be around a four-fifths chance of beating your target over a 10-year period.

I wouldn't worry about having a higher equity weighting than is generally advised for someone of your age. The idea that we should own fewer equities as we age is in many cases plain wrong. You are right to think of your DB pension income as if it were a bond. And having a big bond-like holding means you can safely take on more equity risk, as what matters is your portfolio as a whole.

You ask how to invest the lump sum. What you shouldn't do is wait for the 'right time' to enter the market. Waiting to buy on a dip is dangerous as the market could rise further. Drip-feeding is a better idea: in effect, each £1,000 buys more stocks when they are cheaper and fewer when they are expensive, thus helping to smooth returns.

As for where to hold the lump sum in the interim, I'd prefer cash. Gilts carry downside price risk: if short-term rates rise you might well lose. Their benefit is that they insure you against some share price falls. But as you'll be able to buy more equities with your lump sum if they fall, I'm not sure you need that insurance.

 

Katharine Lindley, chartered financial planner at EQ Investors, says

Phasing an investment reduces the downside risk of investing, so gradually drip-feeding your tax-free lump sum into the market would be a sensible decision. We'd suggest retaining the money in cash during the phasing period, rather than short-term gilts. You could always use National Savings & Investments (NS&I) products if you are concerned about Financial Service Compensation Scheme limits on cash.

Your planning strategy looks sensible, using DB pension to provide a secure retirement income, and supplementing this with a combination of the DC pension and personal investments. You may want to consider topping up your wife's pension and making annual contributions of up to £3,600, which would cost £2,880 as tax relief is added.

It would be sensible to check the functionality offered by the DC pension. The company scheme might not support all the retirement and death benefit options available under pension freedoms, such as the ability to phase taking benefits over five years. If not, you might need to transfer to a more flexible pension scheme, such as a self-invested personal pension (Sipp), ahead of retirement.

Before starting to draw benefits it would be worth getting some specialist advice to help assess your retirement options.

 

Colin Low, managing director of Kingsfleet Wealth, says:

I would suggest not drawing your pension commencement lump sum in one go other than from the DB scheme. Hold the DC scheme in abeyance until those funds are required and then start to draw the tax-free cash.

Why do you need to draw down the DC pot so rapidly? Why not leave the fund as it is, simply taking withdrawals as and when additional funds are required? Investors often overlook the tax-efficient growth that is available within a pension and only focus on the taxation as the funds are withdrawn. However, if the funds are going to be left in a Sipp for some period of time, perhaps even throughout the rest of an investor's life, then why accelerate the withdrawals to take the money out from a tax-efficient environment into one that is subject to a potentially higher rate tax?

Use all the tax available income generating options. You should use your annual allowance for pension income, but also draw from Isas, venture capital trusts (VCTs), bonds and pension commencement lump-sum payments each year to make up the income that you and your wife require.

 

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

I like your big holdings in tracker funds. And some of your active fund holdings – City of London Investment Trust (CTY) and CF Woodford Equity Income (GB00BLRZQ737) – seem reasonable. These invest heavily in big defensive stocks, which tend to do well over the long run on average – the recent underperformance of CF Woodford Equity Income might well be an aberration.

But I'm not sure it's wise to buy VCTs for their tax advantages. Often with tax breaks what you save in taxes you lose by buying overpriced assets. This has been the case with many Aim shares for years.

However, I find it plausible that future growth will come from outside quoted companies – the best UK investments over the next, say, 30 years might not be quoted on a market yet. So VCTs might give you exposure to such growth. In a sense, they hedge against creative destruction risk – the danger that incumbent quoted companies will be out-competed by new companies.

You are right to hold several VCTs. There's big fund manager risk in VCTs because it's hard to spot the minority of companies that will go onto great success.

Another issue is that you are overweight in UK stocks and underweight overseas ones relative to the world market. This is, in effect, a bet that history won't repeat itself: for years the UK has underperformed the world market in sterling terms.

I'm in two minds here. I fear there is a danger that UK-based companies could suffer ongoing weak growth partly, but not only, because of Brexit. But it's possible that sterling is cheap so big holdings overseas might suffer currency losses over the medium term. 

 

Colin Low says:

Much of your current investment approach seems sensible. But you are being somewhat optimistic in terms of your expectation of investment returns, on what the impact of falling markets would be or the availability of work if there was a shortfall in income. 

The portfolio lacks alternative assets or, at least, is insufficiently diversified away from equities. There is a small allocation to fixed income such as bonds and gilts, but some commodity funds and hedge strategies would diversify it further.

 

Mike Neumann, head of investment management at EQ Investors, says

You have put together a well-diversified portfolio with a mix of different asset classes and regions. You are investing in both active and passive investment strategies, and also making full use of your annual Isa allowances.

To achieve optimal asset allocation, you could apply and maintain allocation ranges to asset classes and equity exposure. When the range limits are reached, you could rebalance to remain on course. This would include ranges for the capitalisation split and overseas equities that would also help to manage your currency exposure.

You could consider reducing the exposure to long-duration bonds from iShares Core UK Gilts UCITS ETF (IGLT). Inflation is currently higher than the prevailing yield on bonds.

We'd also suggest some conventional commercial property exposure.

With capital gains tax (CGT) rates lower than income tax, it is good practice to ensure that the highest-yielding investments are sheltered in Isas to maximise tax advantages. Any remaining income investments should be held by whichever of you is the lower-rate taxpayer. You could also use your annual capital gains allowance, which is currently £11,300, to 'wash-out' unrealised gains.

Downing Two VCT (DP2K) is a limited life structure so this source of tax-free dividend income will disappear once the company enters solvent liquidation. You may want to replace this holding, subject to prevailing conditions and legislation at the time it winds up.