Move some of your wealth into safer assets

"I am aiming for an income of 4 per cent a year, plus some growth, as my investment focus is moving from growth to income," says Andrew. "I have recently stopped reinvesting my dividends to help fund my retirement. But I am aware that we might live for another 20 years or more, so should still aim for some growth – especially as inflation may be taking off again.

"My wife and I recently moved to a larger house after an attempt to downsize didn't work out. We used the tax-free portion of my wife's Sipp to help furnish our new house and intend to do the same with my Sipp.

"The investments in our Sipps are to help fund our retirement in later years, and are held in these wrappers to try to reduce our heirs' inheritance tax (IHT) bill when we die. But I am not certain how to ensure that our heirs pay the minimum amount of IHT possible, while retaining enough for us to live comfortably in our old age, with enough to pay for long-term care if necessary.

"I would also like to gift £100,000 to our son, and I intend to draw from my Sipp to do this. I would like to continue to make payments to both my children but not leave ourselves short of funds in our old age.

"I have managed the portfolios for seven years, although started investing 40 years ago via a financial adviser, encouraged by my father and father-in-law. Hanson and Royal Dutch Shell (RDSB) were two of my first investments, which I held for many years successfully.

"I have also started to build a portfolio within an individual savings account (Isa).

"I am looking to reduce my number of holdings and have recently been cutting direct shareholdings. For example, I recently sold Persimmon (PSN) out of my Isa portfolio, and Dignity (DTY). However, I am thinking of adding RPC (RPC), Marston's (MARS) and Pennon (PNN).

"During the past four years I have moved more of my assets into investment trusts, and recent purchases include Worldwide Healthcare (WWH). I am a fan of investment trusts because I want more free time in retirement and to be able to travel without the restrictions of running a portfolio of direct shares.

"My strategy is to stay invested and not change my holdings frequently. I have experienced a couple of downturns, so realise that the market can fall drastically, but am reasonably relaxed about this happening. I think there will be a big correction in the next few years." 

Andrew and his wife's portfolio

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:

I think it is dangerous to think about investing for income rather than capital gains. Income stocks generally fall into three different categories, each of which is risky.

The most risky type are the recovery plays – stocks of which the prices have fallen a lot, such as Micro Focus International (MCRO) or Marston's. Buying these is a bet against momentum. That's risky because past fallers tend, in the short term, to continue falling. There's big upside potential in these if you time your buying right, but big downside if you don't.

Cyclical stocks such as housebuilders or industrials, for example DS Smith (SMDS), are also risky. These do well in normal economic times, but slump in recessions. Because you are retired and don't need to worry about losing your job or business, you are better placed than others to take cyclical risk. Just be aware that it's a big risk.

The third sort of income stocks are large mature companies that investors think have low growth prospects. Historically, these have been good buys as investors have under-rated the ability of such stocks to grow by using brand power to fend off competition. But these too are risky because it's possible that investors have now wised up to that error, meaning such shares are no longer underpriced. And utilities carry political risk.

For these reasons, you should not worry about income. What matters is total return. You can create your own dividends by selling some of your holdings each year: you and your wife each have an annual capital gains tax (CGT) allowance to offset any gains against, which for the current tax year is £11,700.

Onochie Eneh, investment manager at Redmayne Bentley, says:

As you are looking to mitigate IHT you could consider allocating some of your portfolio to Alternative Investment Market (Aim) companies that qualify for business property relief (BPR). There are many advantages to holding these, including remaining in control of your investments should you wish to access them in future years. If you make gifts, they can take up to seven years to be completely IHT-free, compared with two years for a BPR-qualifying investment.

But Aim-traded companies be high risk and may be more volatile than companies listed on the main market. Tax rules and reliefs could also change, and there is no guarantee that a company that qualifies for BPR today will qualify in the future.

Ben Yearsley, director at Shore Financial Planning, says:

Now that the dividend allowance has fallen to £2,000 a year investors with income-bearing assets held outside tax-efficient wrappers will regret not having made use of the valuable benefits of individual savings accounts (Isas), into which you can now put assets worth up to £20,000 per person per tax year.

You have a sizeable pot to live off – about £1m excluding your Sipps – it's just a shame that so little is held in Isas. If you and your wife had used your Isa and personal equity plan (Pep) allowances every year, most of this portfolio would be in a tax-efficient environment and you would be able to take a tax-free income from it. But only about £230,000 is in Isas.

It makes sense to use your Isa allowances every year, if necessary using your CGT allowance to transfer assets into them, to reduce the amount of tax future growth and income will incur. I would ensure the highest-yielding investments are in the Isa to make the most of the tax-free income.

Your goal of 4 per cent income plus some capital growth is quite reasonable. If you are relying on your investments to maintain your lifestyle, as you might need them to do this for 30 years, you still need your investments to grow and enable your income to grow over time. Otherwise inflation will erode your spending power.

With regard to IHT, you and your wife should be able to take advantage of the main residence nil-rate band, which this tax year adds an additional £125,000 to each of your £325,000 IHT allowances, assuming you plan to leave your estate to your children or grandchildren. That gives you and your wife a combined IHT allowance of £900,000.

Some investments benefit from BPR, meaning they fall outside of estates for IHT purposes if you have owned them for at least two years at the time of your death. However, most have a low target return, and are unlikely to offer 4 per cent income and capital growth.

You could also buy Aim-traded shares, which also qualify for IHT free status after two years of ownership. But many Aim companies that seem attractive and pay dividends look expensive as money has flooded into this area over the past few years.

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

You are wise to try to shift from direct shareholdings into investment trusts. Doing this could be a cheap way of getting a diversified portfolio that you do not need to monitor or trade as often as direct shares.

However, watch their discounts to net asset value (NAV). If a trust is on a tight discount or a premium relative to its historic discount, this can be a sign that sentiment towards the trust and its underlying assets is unusually bullish. And that can be a warning sign of low future returns. But unusually wide discounts can be a sign of bargains.

Also, if global equities fall, many investment trusts' share prices are likely to fall too. This is a brute mathematical fact. If you hold lots of shares, you spread the risk of any individual share falling. But you also get more exposure to the risk of shares falling together.

In this context, it's odd that nearly all of your assets are in equities if you are expecting a big correction. You might want to consider shifting some of your wealth into safe assets such as cash. Doing this means sacrificing some upside potential, but it would also give you peace of mind.

Put it this way. Assuming equities offer a real total return of 5 per cent a year, you could withdraw over £60,000 a year without, on average, eating into your capital. If this is more than enough for your needs, you could afford to sacrifice potential returns and put some more of your assets into cash.

Onochie Eneh says:

"Your portfolios have no allocation to fixed interest. You could be forgiven for this because it is expected that interest rates will rise, which could lead to yields rising and potential loss of capital on redemption. But a potential solution is a short-duration fixed-income fund, which could reduce volatility as the bond investments it holds are closer to maturity. Investing in bonds via a fund also means that reinvestment costs are likely to be lower than if you invested directly in bonds. 

Because of your income preferences you should also consider introducing alternative assets to your portfolio. Infrastructure and property investment trusts are a way to boost income yields and can provide your portfolio with stability. Many such trusts' income revenues are linked to inflation, which helps maintain the income they pay to investors. 3i Infrastructure (3IN) has performed strongly over the past five years, and invests in a balanced portfolio of infrastructure and greenfield products in developed markets. 

Your portfolio also has a large weighting in direct equities, which account for around a third of it. Given recent market uncertainty, equities have been incredibly volatile and having a large proportion of your portfolio allocated to direct equities increases its risk. You are looking to achieve a yield of around 4 per cent to supplement your pension, but your direct equity investments run the risk of dividend cuts, which makes them less dependable. So consider increasing your allocation to collective funds such as investment trusts and open-ended investment companies.

Ben Yearsley says:

If your want to take a more of a backseat role with regard to managing your portfolio, it would be sensible to further reduce the number of direct shares, and replace them with investment trusts and funds. Collective investments need far less monitoring than individual shares. 

This portfolio is quite high risk, so do you want that level of risk?

And you don't have many core holdings. I'd look to add a few investment trusts that I consider to be lower risk when you sell some of the direct shares. For example, Personal Assets Trust (PNL) managed by Sebastian Lyon and RIT Capital Partners (RCP).

I would also add some more equity income via Standard Life Equity Income Trust (SLET), which is managed by Thomas Moore and yields about 4 per cent.

Many of the investment trusts you currently hold aren't particularly high-yielding so consider switching some of them for trusts such as Temple Bar Investment Trust (TMPL), which I have recently added to my own portfolio. This has a yield of 3.3 per cent and is a recovery value play on the UK market. Equity income is a good core for a portfolio, and these two along with your existing holdings in JPMorgan Claverhouse Investment Trust (JCH), Mercantile Investment Trust (MRC), and some of your direct shares such as Aviva (AV.), Prudential (PRU) and Unilever (ULVR), could provide that core income.

I would also add some Asian income – my preferred option is Schroder Oriental Income Fund (SOI) managed by Matthew Dobbs. I am a big fan of Asia for long-term investing, and companies there have become much more aware of the need to pay a consistent income.