Dave is 56 and earns around £72,000 a year net of tax, and expects his earnings to keep pace with inflation until he is 65. He owns 50 percent of a business that makes pension contributions of £24,000 a year and his wife has a small local authority average salary scheme pension. Their home, which is worth around £825,000 has a mortgage of £400,000 on it, and his wife owns another property worth around £200,000.
Sipp, cash and property
10 per cent total return a year to build up £900,000 pension fund in eight years and help children
"I am aiming for an average total return of 10 per cent a year for the next eight years from my self-invested personal pension (Sipp) portfolio," says Dave. "I plan to add £2,000 a month to it during this period, and hope to create a total pension fund of £900,000 by the time I am 65.
"I plan to withdraw my tax-free lump sum [of 25 per cent of the value of the pension] at age 65, and then drawdown income of 4 per cent to 5 per cent a year. However, as I expect to realise between £400,000 and £500,000 from my business in cash by the time I am 65, I should be able to defer drawing my pension benefits for up to five years if necessary. And we expect to inherit around £300,000 in the next two years.
"We also have cash of around £30,000 readily available, and my business generally holds around £60,000 to £70,000 in cash.
"My children will be aged 25 or over by the time I am 65, and I want to give two of them £75,000 each in cash at the time of my retirement. The other child has severe learning difficulties so I want to create a degree of financial independence for him over the long term. I plan to do this by meeting some of his expenses during my lifetime, and setting up a bespoke discretionary trust for him after I and my wife die. I will pass the remainder of my assets to my other children.
"I plan for my Sipp to be in capital accumulation for the next five years, so I am happy to remain mostly invested in equities. I think there is little value in other assets and introducing them would mean I am unlikely to meet my target of £900,000 by the time I am 65.
"I can tolerate some volatility over the next five years and would be prepared for falls in value of between 15 per cent and 20 per cent. But when I am around three years from my planned retirement age of 65 I will look to reduce volatility.
"I have been investing for five years, and like investment trusts because I think the ability of some of their managers and their discounts to net asset value (NAV) offer some protection. I have deliberately introduced a range of different managers, and tried to strike a balance between trusts' performance record, discount to NAV, yield and charges.
"I do not wish to invest in individual stocks at this stage as I don't have time to research them and I am concerned that they may be too volatile.
"I am cautious on the outlook for the UK so I'm underweight this area, and overweight Asia Pacific and emerging markets. I try to maintain broad geographical, sector and theme diversification with a bias towards smaller growth oriented companies, and some balance between growth and income.
"I sold some of my holding in Baillie Gifford Shin Nippon (BGS) because I think its premium to NAV is unsustainable. I reinvested the proceeds in Fidelity Japanese Values (FJV) because I prefer the discount to NAV it is trading on. I also think this trust's gearing (debt) could boost its growth.
"I also reduced my holding in TR European Growth (TRG) and reinvested the proceeds in JPMorgan European Smaller Companies (JESC) for similar reasons.
"I am thinking of investing in India Capital Growth Fund (IGC) instead of Aberdeen New India (ANII), Schroder AsiaPacific Fund (SDP) instead of Scottish Oriental Smaller Companies (SST) and Templeton Emerging Markets Investment Trust (TEM) instead of JPMorgan Emerging Markets (JMG)."
Dave and his wife's portfolio
Holding | Value (£) | % of portfolio |
JPMorgan US Smaller Companies Investment Trust (JUSC) | 17,040 | 1.28 |
Monks Investment Trust (MNKS) | 15,970 | 1.2 |
Henderson Eurotrust (HNE) | 15,760 | 1.19 |
JPMorgan European Smaller Companies Trust (JESC) | 15,422 | 1.16 |
Scottish Mortgage Investment Trust (SMT) | 13,462 | 1.01 |
Invesco Asia Trust (IAT) | 12,581 | 0.95 |
Fidelity Japanese Values (FJV) | 11,847 | 0.89 |
Merchants Trust (MRCH) | 11,364 | 0.86 |
Allianz Technology Trust (ATT) | 11,312 | 0.85 |
JPMorgan Mid Cap Investment Trust (JMF) | 11,275 | 0.85 |
Pacific Horizon Investment Trust (PHI) | 11,224 | 0.85 |
Henderson Far East Income (HFEL) | 11,161 | 0.84 |
JPMorgan Emerging Markets Investment Trust (JMG) | 11,142 | 0.84 |
Edinburgh Worldwide Investment Trust (EWI) | 10,828 | 0.82 |
International Biotechnology Trust (IBT) | 10,814 | 0.82 |
Henderson Smaller Companies Investment Trust (HSL) | 10,687 | 0.81 |
Scottish Oriental Smaller Companies Trust (SST) | 10,632 | 0.8 |
Baring Emerging Europe (BEE) | 10,540 | 0.79 |
Standard Life Private Equity Trust (SLPE) | 10,511 | 0.79 |
Aberdeen New India Investment Trust (ANII) | 10,243 | 0.77 |
BlackRock Frontiers Investment Trust (BRFI) | 6,620 | 0.5 |
BlackRock Latin American Investment Trust (BRLA) | 5,878 | 0.44 |
TR European Growth Trust (TRG) | 1,259 | 0.09 |
Baillie Gifford Shin Nippon (BGS) | 755 | 0.06 |
Cash | 43,398 | 3.27 |
Property | 1,025,000 | 77.26 |
Total | 1,326,725 |
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:
One problem is that your expectations are too high. A 10 per cent total return over eight years implies that you will double your money, before additional savings. But history warns us that this is unlikely.
Let's take the total returns in sterling terms of MSCI World index after inflation as a guide. Since this index began in 1969 there have been three eight-year periods when returns have been this high. However, two followed periods of very low prices after the early 1980s and 2009, and in 1999 prices were bolstered to unsustainable levels by the tech bubble. As repeats of these are improbable you should lower your expectations.
Does this matter? In one sense, no. Your other sources of funds – an inheritance and the sale of your business – reduce your reliance upon the market.
But it looks like your income in retirement will fall short of your current income. To get a post-tax retirement income of £72,000 requires a pension pot of around £2m. Even with your other revenues you'll probably fall short of this. Ask yourself whether you could cope with this, or whether you can adjust in other ways such as selling property.
My point is that you mustn't rely on this portfolio making high returns.
James Baxter, managing partner and head of private clients at Tideway Investment Partners, says:
Your pension is invested in capital growth focused investment trusts. Although these are not bad investments, and might do very well, they look out of place in a pension fund.
They are high risk and there is a high degree of uncertainty over the returns they will generate over an eight year period. They could fall woefully short of your 10 per cent a year target or exceed it - there is very little visibility on what the actual returns will be. This renders your current plan as a bit of a high wire act: it might work and deliver a fantastic result, but there is a big risk it could go horribly wrong.
Holding these investments in a pension fund is also tax inefficient if they perform well. The vast majority of return will come as capital gains, and while you can take 25 per cent of your pension tax free, when you draw on the remaining 75 per cent it will be taxed at your marginal income tax rate. This is likely to be higher than the capital gains tax (CGT) rate you would incur if the investments were held outside a tax efficient wrapper. If you held these investments outside the pension, as you realise them you and your wife each have an annual CGT allowance to offset the gains against, which for the 2018/19 tax year is £11,700.
In a worst case scenario, holding growth investments like this in a pension fund might mean you pay 40 per cent income on a capital gain that could have been enjoyed tax free outside the pension fund.
A lower risk strategy would be to increase your annual pension contributions to the maximum £40,000 a year to generate more risk free tax relief, but aim for a lower total return using more income focused equity funds blended with some higher yielding fixed income. The equity fund dividends and bond coupons, which could be reinvested and over time would underpin the return, would give a more certain outcome. A 6 per cent a year return with the higher £40,000 contributions on top of the current fund value would give a more certain £750,000 fund by the time you are 65.
Your growth focused investment trust portfolio could be recreated in general investment accounts to provide a second pool of capital outside of pension funds. A 25 per cent tax free cash sum could be taken from the current pension fund to start this off, supplemented by the inheritance money as it comes through. Overall this would give a more balanced and tax efficient approach.
Freddie Cleworth, chartered wealth manager at EQ Investors, says:
Having established a sufficient liquid cash fund you should look to invest from the inheritance before retirement, using indvidual savings accounts (Isas) and other personal allowances. These investments could be partly used to repay your mortgage, and also help reduce dependence on your Sipp and having to hit a high target return every year until retirement. If markets suffer a serious setback relying on your Sipp alone could be insufficient. As you approach retirement you could gradually reduce investment risk.
If things do go well until you retire you could realise around £225,000 tax-free cash from your Sipp. However, it could make sense to consider taking money from Isas, too. Allowing the Sipp to grow for longer potentially increases tax-free cash, and if you die before age 75 the Sipp could be passed on free of inheritance tax.
A mixture of Isa withdrawals and Sipp tax-free cash would enable you to make a gift of £150,000 to your children, and give you liquidity while you are rotating the Sipp into income-producing products. This liquidity will be important if it takes longer than desired to realise funds from your business.
Depending on your expenditure, the income portfolio could be given time to settle for one to two years before being needed to pay out income. Income withdrawals could then be flexibly managed to mitigate sequence risk and avoid pound-cost ravaging, which can severely deplete asset values due to making withdrawals during a downturn.
HOW TO IMPROVE THE PORTFOLIO
Chris Dillow says:
This portfolio itself is well-diversified. But there's a risk that diversification across equity funds cannot remove – that of the world market falling and dragging down funds generally. This is especially great in the case of this portfolio because it is laden with funds that carry lots of such risk, for example, ones focused on emerging markets and smaller companies.
We can roughly quantify this. Since 1969, the standard deviation of MSCI World index's annual real returns in sterling terms has been 18 percentage points. If we assume, very generously, an average annual real return of 7 per cent then you have a roughly one-in-12 chance of losing money – even over eight years. And you have around a one-in-six chance of seeing your money grow by less than 25 per cent over this period – far less than the doubling you're aiming for.
Some of these funds will beat the market. But the thing about diversification is that it reduces upside potential as well as downside risks: the performance of good funds will be offset by that of bad ones. And if you are only diversifying across equities this leaves you exposed to market risk. The assets outside your pension – your likely inheritance, cash and the business – diversify market risk. But are you sure these are sufficient?
I also want to clarify what discounts to NAV on trusts can indicate. Discounts can vary across trusts for many reasons, such as management fees or the difficulty of valuing the underlying assets. Such differences might not tell investors very much.
What does tell us something is a trust's discount relative to its own history. If this is small, it can be a sign of high investor sentiment not just towards the particular trust but towards its asset class in general. In the long run, however, sentiment tends to mean-revert, which means that positive sentiment resulting in a small discount can lead to falling prices. In this sense, you are right to be wary of trusts whose discounts are unusually low.
Freddie Cleworth says:
You have taken an adventurous approach in your Sipp, targeting 10 per cent a year for the next eight years. Your Sipp is mostly invested in equity funds with an allocation of around 40 per cent to Asia Pacific and Emerging Markets.
Over five years your current Sipp portfolio has made an annualised return of 15.7 per cent so it has been on track, even after accounting for fees. But this level of return seems unlikely to continue. And it is likely there will be greater volatility relative to the past five years, such as the recent impact protectionist policy announcements from the US and China have had on markets.
Higher weightings to the financial services and technology sectors of about 19 per cent and 24 per cent, respectively, are worth monitoring and rebalancing if growth continues. Be aware that 25 per cent of your Sipp has exposure to underlying assets denominated in US dollars. If sterling appreciates your return will be diminished on conversion. Currency fluctuations are hard to predict so opt for products hedged to sterling where possible.