Rethink your heavy income focus

"We want an income from our individual savings accounts (Isas) of £800 per month, growing at CPI inflation plus 1 per cent – or more if achievable – from April 2019," says Andrew. "This will be to fund expenses such as new cars, home maintenance and white goods, and partly fund holidays.

"The capital in the Isas will be used to fund end-of-life care as required. We do not have any children and our estate will be left to charity when we have both died, so we are not concerned about inheritance tax.

"We will move £80,000 of cash savings into equity investments in our Isas over the next two years, and will transfer our Sipp assets into these as tax-efficiently as possible from 2021.

"Helen can receive a CPI inflation-linked NHS pension of £3,600 a year from 2025, and we are due to start receiving our old age pensions from 2028 and 2032.

"I have been investing for 32 years and over the years have seen markets rise and fall, but continue to believe that equities are the best investment over the long term. During falls we stay invested and take comfort from the flow of dividends. A loss of 30 per cent or more in any given year would be upsetting, but we would stay invested. What would worry us more would be a reduction of 30 per cent or more in dividends in a year.

"Two years ago around 85 per cent of our equity portfolio was allocated to the UK, but fears about the economic impact of Brexit and a government led by Jeremy Corbyn and John McDonnell have led us to significantly increase our non-UK focus. But is too much of our portfolio still hostage to the UK's fortunes?

"Most of our equity allocation used to be in direct shareholdings and I gained a lot of enjoyment from stock selection. But as we approach full retirement we prefer exchange traded funds (ETFs) and investment trusts because we think they are likely to be lower risk. We have also reduced our number of holdings from around 40 to 19.

"Our portfolio is income focused – is that right, or should we look more for capital growth to provide our future income needs? And are we right to have a low allocation to bonds?

"We rely on Investors Chronicle and the business sections of the daily papers for ideas, and do our own research. We have never used a financial adviser.

"Recent trades include buying Vanguard FTSE All-World High Dividend Yield UCITS ETF (VHYL) and Schroder Oriental Income Fund (SOI), and selling Perpetual Income & Growth Investment Trust (PLI).

We are thinking of topping up our investments in Schroder Oriental Income and European Assets Trust (EAT), and adding Scottish Mortgage Investment Trust (SMT) to Helen's Sipp.

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 ask whether your allocation to bonds is too low. I don't think so. Think of government bonds as insurance. They pay out in some circumstances in which share prices fall – if investors become more risk averse or pessimistic about economic growth. But they might well lose money otherwise.

Such insurance is worth having if the possibility of equity prices falling worries you. But you say you're willing to ride out falls, and you seem to be in a position to do so. This portfolio is more than sufficient to generate your target level of income and your high cash weighting will help smooth the returns on your overall portfolio if equities do fall.

Duncan Arthur, chartered financial planner at Blackadders Wealth Management, says:

Consider how much income you actually need to take from your savings and investments to meet your planned expenditure. There is little benefit in withdrawing cash tax free from your Isas unless you are going to spend it. 

To generate a monthly income of £800 when the business is wound up in 2022, you could initially use your available cash and the taxable element of Helen's Sipp to use up her Personal Allowance at the time. The tax-free cash element of the Sipp could be used for any planned lump sum expenditure, and this would leave the Isa assets to grow in a tax-efficient environment until they are really needed. 

Transferring your Sipp assets into your Isas means moving them from an environment that is IHT free to one that is not, altbough that doesn't seem to be a problem for you. However, we would still advocate caution as you may face a tax liability when you withdraw assets from the Sipp. You could instead exhaust the capital value of the Sipp over time and minimise tax by using Helen's personal allowance.

From the 6 April this year, the tax-free dividend allowance will fall from £5,000 to £2,000. You should adjust the salary and dividends from the consultancy business to maximise Helen's income and dividend tax allowances.

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

You also ask if your portfolio is too income focused. I hate the idea of income stocks. Talk of income confounds two very different types of stock.

Some stocks and the funds that invest in them have high yields because they are recovery plays or vulnerable to recession. Current examples include Provident Financial (PFG), and less recent examples are miners and housebuilders. There are also large, mature companies that the market believes have gone ex growth so offer high dividends to compensate for an expected lack of growth.

Recovery and cyclical plays are risky. Recoveries sometimes don't happen, for example, Carillion (CLLN) was on a nice yield last year. And while cyclical stocks offer great returns in economic upswings they can suffer terribly in downturns – income stocks such as housebuilders and mortgage lenders were disasters in 2008 and 2009, for example.

So called ex-growth stocks, on the other hand, have often been good investments. Investors have tended to underrate the ability of large companies to grow profits simply by using their size as a means of excluding rivals from the market: they have underpriced what Warren Buffett calls economic moats.

So, rather than consider whether you have too many income stocks, you should think about what type of income you have: is it moat or cyclical income?

Most of your holdings are moat income. City of London Investment Trust (CTY), for example, holds larger UK defensive stocks and North American Income Trust (NAIT) holds larger US defensives. Monks (MNKS), meanwhile, invests in Amazon (US:AMZN) and Alphabet (US:GOOGL), better known as Google.

This seems reasonable. But the question is, have investors wised up to their past errors so that they are now pricing moats more correctly, in which case future returns won't be so good? We cannot answer this with any confidence, which is perhaps one reason for diversifying income stocks by holding trackers alongside them, as you do.

I don't think you have too much UK exposure because abandoning the UK entirely would incur two risks. Because UK stocks have underperformed the rest of the world for so long they might be relatively cheap. I agree that the outlook for the UK economy is not good but there must be a point at which this is priced in.

The second is that sterling might well be cheap: we know that exchange rates often overshoot their fair value. If it rises, sterling denominated returns on overseas stocks would be poor even if those stocks do okay in local currency terms, and that is doubtful.

So, overall, I think this portfolio is okay.

Peter Doherty, chief investment officer at Tideway Investment Partners, says:

We have a strong preference for using active management strategies for equity income. Buying stocks purely because they have a high dividend yield with little regard for the fundamentals is a very risky business, and funds such as SPDR S&P UK Dividend Aristocrats UCITS ETF (UKDV), Vanguard FTSE All-World High Dividend Yield UCITS ETF and SPDR S&P Global Dividend Aristocrats UCITS ETF (GBDV) will underperform active strategies.

A case in point in this sector in 2017 was General Electric (US:GE). The company offered a nice trailing yield in the summer of around 4 per cent despite having dividend cover under 1.5 times, increasing leverage and limited cash flow. The stock fell around 45 per cent over 2017 – a loss that could have been avoided by an active manager who would have seen it coming.

A well-managed consistent active fund is Unicorn UK Income (GB00B00Z1R87), which has a long track record of delivering solid income and currently has yield of about 3.7 per cent. 

Alongside this our preference is to allocate to complementary active management strategies that focus on growth and value investing, which tend to outperform at different points in the market cycle. So, rather than funds such as iShares Core FTSE 100 UCITS ETF (ISF) we allocate to Lindsell Train UK Equity (GB00BJFLM156) for growth and Schroder Recovery (GB00BDD2F190) for value. These are run by managers who have long-term track records of outperformance ahead of ETFs.

And rather than Vanguard FTSE All-World UCITS ETF (VWRL) our preference is for quality global active funds whose managers focus on value and growth. Our current selection for growth is Baillie Gifford Global Alpha Growth (GB00B61DJ021) and for value Artemis Global Income (GB00B5N99561).

The current period of negative real cash rates and gilt yields provides a real challenge for investors who want to earn a positive real return without taking too much risk. So this portion of your portfolio should be reallocated, and an area to consider is hybrid capital bond investment strategies.

Hybrid capital is subordinated debt issued by the world's biggest banks, insurance companies and corporations to provide balance sheet flexibility. Its advantages include a higher return than ordinary debt, higher cash flow than common equity dividends, and exposure to large, household names with an investment grade rating and long track records of meeting all obligations.

We run a fund purely focused on hybrid capital, and other funds that offer exposure to this asset include Janus Henderson Preference & Bond (GB0007651721).

Zubin Kazak, investment manager at Blackadders Wealth Management, says:   

Given your ages, you both potentially have a long investment horizon ahead of you. With no debts or children, and your knowledge, approach to risk and investment experience, you have the capacity to adopt a more balanced investment approach by investing in some equity growth funds.  

Cash dividends are attractive but focusing too heavily on high dividend-yielding funds can mean not exploiting the portfolio's total return potential. Both income and capital returns will be key to meeting your future needs – do not underestimate the power of compound investing. Funding your Isas with your heavy cash weighting over the next two years will provide an opportunity to introduce such a growth slant. We like using passive and active funds for equities, and Fundsmith Equity (GB00B41YBW71) and Scottish Mortgage Investment Trust are good examples of growth funds.

Your portfolio would benefit from broader asset class diversification – although your cash weighting helps offset equity risk we would not totally avoid fixed income and other alternatives. Fixed income funds can provide a reliable income stream. If capital loss is less of a concern then you could take on some modest duration risk just now. Consider the likes of Premier Multi-Asset Distribution (GB00B40RNW10) or Jupiter Strategic Bond (GB00B544HM32).

Your longer-term goal of leaving any surplus funds to charity is commendable so adopting a growth stance will hopefully leave a larger residual pot. Think about whether a charitable trust might help you achieve a more lasting legacy. This would give you some degree of control over how your estate is distributed so would have a greater meaningful long-term impact than an outright gift.