William is age 51 and in full-time employment, and hopes to retire at 60 with an income of about £30,000 a year. He has a defined-benefit (DB) pension with a value of about £679,240, and his home is worth around £360,000 and mortgage-free.
Isa, Sipp and trading account invested in funds and ETFs. Cash, residential property and land
Total return of 5% a year over next 20 years, cut number of holdings and investment costs, pass on assets to relatives and charities
He also owns a flat worth £750,000 on which there is an outstanding interest-only mortgage of about £236,500 with an interest rate of 2.09 per cent. He lets it and the rental income covers the mortgage and expenses. William is a higher-rate taxpayer.
"I want my investment portfolio to make a total return of 5 per cent a year over the next 20 years. I will not draw on the portfolio for the time being unless something major happens like redundancy or ill health. And I am building up a larger cash reserve, ideally of £50,000, to cover emergencies and possible care costs.
"I am single with no dependents, but want to build a legacy for my relatives and for charities to which 10 per cent of my estate is left.
"Should I pay off the interest-only mortgage on my rental property? I have exchange traded funds (ETFs) that I could encash to pay this off. These make total returns of around 5 per cent a year.
"I plan to dispose of portfolio holdings with a value of less than £10,000, with the exception of those that cannot be encashed until my mother dies. I want to invest the proceeds in non-equity investments such as bond funds to give the portfolio more stability.
"I want to simplify the administration of my portfolio and reduce the number of holdings, using my annual capital gains tax (CGT) and individual savings account (Isa) allowances.
"I want to minimise my costs of investment, and over the past four years I have sold a number of active funds and reinvested the proceeds in ETFs.
"I have been investing since 1992 and would say that my attitude to risk is high as I am prepared to lose up to 20 per cent in any given year. I am generally a buy-and-hold investor, and try to ignore short-term issues – I prefer to take a long-term view.
|Holding||Value (£)||% of the portfolio|
|Alliance Trust (ATST)||9,272.62||0.36|
|Aviva Life Managed AL6 Life (GB0003195798)||30,285.27||1.16|
|BlackRock World Mining Trust (BRWM)||640.77||0.02|
|ETFS Agriculture ETC (AGAP)||944.13||0.04|
|L&G Gold Mining UCITS ETF (AUCP)||690.27||0.03|
|Foreign & Colonial Investment Trust (FRCL)||12,265.25||0.47|
|ICG Enterprise Trust (ICGT)||15,215.88||0.58|
|iShares Asia Property Yield UCITS ETF (IASP)||3,438.60||0.13|
|iShares Core MSCI EM IMI UCITS ETF (EMIM)||46,199.11||1.77|
|iShares Developed Markets Property Yield UCITS ETF (IWDP)||48,323.42||1.86|
|iShares European Property Yield UCITS ETF (IPRP)||3,482.47||0.13|
|iShares FTSE 100 UCITS ETF (CUKX)||19,224.22||0.74|
|iShares Global Timber & Forestry UCITS ETF (WOOD)||56,131.34||2.16|
|iShares Listed Private Equity UCITS ETF (IPRV)||88,700.40||3.41|
|iShares MSCI EM Small Cap UCITS ETF (SEMS)||20,318.48||0.78|
|iShares MSCI Europe ex-UK UCITS ETF (IEUX)||46,915.71||1.8|
|iShares S&P 500 UCITS ETF (IUSA)||47,730.30||1.83|
|iShares UK Dividend UCITS ETF (IUKD)||30,698.93||1.18|
|iShares UK Property UCITS ETF (IUKP)||6,918.50||0.27|
|iShares US Property Yield UCITS ETF (IUSP)||3,520.13||0.14|
|L&G Distribution Growth G16 (GB0033161802)||8,973.61||0.34|
|L&G Property G16 (GB0033170860)||10,181.95||0.39|
|Lyxor FTSE 250 UCITS ETF (L250)||54,927.84||2.11|
|Lyxor MSCI World Health Care TR UCITS ETF (HLTG)||72,952.13||2.8|
|Marks and Spencer (MKS)||2,855.33||0.11|
|Old Mutual Wealth AXA Framlington Financial Life (GB0008133166)||5,967.31||0.23|
|Old Mutual Wealth Henderson US Growth Life (GB0008127119)||9,136.84||0.35|
|Old Mutual Wealth Invesco Perpetual Income Life (GB0008099177)||14,145.91||0.54|
|OMW Schroder European Recovery Life (GB0032449026)||11,179.50||0.43|
|Phoenix SM Far Eastern Life (GB0007888786)||3,273.26||0.13|
|Phoenix SM Managed (0-35% shares) Life (GB0007849515)||2,295.59||0.09|
|Vanguard FTSE Developed World ex UK Equity Index (GB00B59G4Q73)||139,709.61||5.36|
|Vanguard LifeStrategy 100% Equity (GB00B41XG308)||145,784.09||5.6|
|Xtrackers S&P Select Frontier Swap UCITS ETF (XSFR)||18,988.78||0.73|
|Xtrackers Stoxx Europe 600 Food & Beverage Swap UCITS ETF (XS3R)||4,325.91||0.17|
|Xtrackers Stoxx Europe 600 Oil & Gas Swap UCITS ETF (XSER)||15,903.65||0.61|
|Lyxor MSCI World Financials TR UCITS ETF (FING)||42,490.89||1.63|
|Vanguard Global Small-Cap Index (IE00B3X1NT05)||43,380.45||1.67|
|Aviva With-Profit GA Life (GB0003635546)||58,302.68||2.24|
|Standard Life Assurance Managed 3 Life (GB00B3L4JR18)||25,017.12||0.96|
|Vanguard S&P 500 UCITS ETF (VUSA)||83,993.58||3.22|
|Vanguard FTSE U.K. All Share Index (GB00B3X7QG63)||64,629.55||2.48|
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:
Paying off your mortgage by cashing in some of your ETFs would make your portfolio safer. Paying off the mortgage is not unlike having cash savings on which there is a good interest rate, and doing this would save you from a triple risk. Higher interest rates would add to your mortgage payments, cut house prices and perhaps also reduce share prices by reversing the reach for yield. So this could be a good option.
This portfolio should easily meet your objective of providing an after-tax income of £30,000 a year. If we take the conventional assumption that you can safely withdraw 4 per cent of your wealth a year without eating into capital, you'll have a pre-tax income of over £50,000 in today's prices even if there's no real growth in the portfolio over the next nine years.
A 0 per cent real return would be a pessimistic assumption, but conversely a 4 per cent safe withdrawal rate might be too optimistic. So net, you are on course to meet your objective.
But there is a clash between your two objectives. You want a total return of 5 per cent a year, but also a greater allocation to non-equity investments such as bonds. You can't have both. The only realistic way of getting a 5 per cent a year total return in real terms is to hold equities and hope that reasonably normal economic conditions continue. Safer bonds offer a negative real return, so a fair-sized holding of them would greatly reduce your chances of an overall return of 5 per cent.
But there is a case for having an allocation to bonds. Your current portfolio exposes you to ordinary market and cyclical risk. A recession would be likely to result in losses for equities generally, especially your cyclical holdings such as iShares Global Timber & Forestry UCITS ETF (WOOD) and Lyxor FTSE 250 UCITS ETF (L250). Bonds would probably protect you from this risk. They'd do well in a recession because in this situation investors would expect more quantitative easing, and would also benefit if investors' appetite for risk or expectations for economic growth reduced.
Higher-yielding corporate bonds are not an option. In normal times they offer higher returns than government bonds, but do badly in recessions as credit risk rises. Think of them as a hybrid of gilts and shares.
The long-run average returns on equities, meanwhile, might not be as high going forward, so the presumption that long-term investors should have huge equity weightings is questionable.
That said, bonds are risky. They could sell off if global interest rates rise by more than expected and/or if US economic expansion continues to exceed expectations. Cash protects you better than bonds from this.
James Norrington, specialist writer at Investors Chronicle, says:
Your pension pots are collectively worth around £830,000, so you are about £200,000 away from hitting the lifetime allowance, something to watch out for when making further contributions over the next nine years.
The DB scheme is a good safety net as with this you don't bear any of the investment risk – this falls upon your employer. So as over 80 per cent of your current pension pot is pretty much guaranteed, your first port of call in terms of tax-efficient wrappers should be your annual Isa allowance, which is currently £20,000.
As you work, own your primary residence and can cover the capital value of the remaining mortgage on your rental property there is no rush to pay this debt off. Interest rates are forecast to rise only slightly, so the opportunity cost of foregoing the potential equity returns is greater than what you'll save on finance. Share prices could fall, but so could the value of London property. So if you remain liquid and solvent, think of low interest rates as an efficient use of debt to leverage your investing potential.
Peter Savage, chartered financial planner at Fairstone, says:
Given the size of your portfolio, your requirement of around £30,000 a year after tax is a modest amount, especially as you intend to try to achieve a return of 5 per cent. You could easily afford to take a higher income, especially in the early years of retirement as these are the fun years. There will be a time when you are less active due to age and inevitably will require less income.
Your target of 5 per cent a year over the next 20 years is achievable, but given your modest income needs you will be investing for the benefit of someone else. If this is the legacy you mentioned, you should consider investing some of your portfolio in Alternative Investment Market (Aim) shares, which qualify for business property relief. If held for two years, these become exempt from IHT. Aim-traded shares can be held in an Isa.
As you already have around £40,000 in cash, it should be easy to reach your £50,000 target. When you are able to dispose of the holdings from your mother, I would suggest disposing of the small ones and topping up your cash reserve with the proceeds.
Your capital is working harder and earning you more money than the cost of interest. However, there may be a time when this isn't the case. From 6 April 2020, tax relief for mortgage interest will be restricted to the basic rate of income tax – 20 per cent. This and any potential interest rate increases on your mortgage would mean that your costs increase and you could be losing out, if the money you have invested is earning less than these costs. I would monitor this situation and when this scenario arises, consider paying down the mortgage.
Your portfolio could easily generate the required income for care costs. According to a report by healthcare specialist Laing & Buisson in 2013-14, residential care homes can cost an average of £29,270 a year, or £39,300 a year if nursing is required. According to Saga, the average stay in a care home is two-and-a-half years. Your liability for care could be around £100,000 – £40,000 a year for two-and-a-half years. I would keep this money invested and sell down when required.
Pensions are a great way to leave a legacy to relatives as they can be passed on without becoming part of your estate for inheritance tax (IHT) purposes. If you die before the age of 75, your self-invested personal pension (Sipp) could be passed on ta- free to your beneficiaries. If you die after age 75 those receiving money from inherited pensions are taxed at their highest rate, for example a basic-rate taxpayer will pay 20 per cent and if they take enough to push their total income over £45,000 a year then they will be taxed at 40 per cent. Someone who has no other taxable income could currently take up to £11,800 – the personal allowance – from a pension inheritance every year and pay no tax on it.
So I suggest that any withdrawals from your investments are taken from your Isa, leaving the pensions to be passed on after you die. Withdrawals from your Isa are tax-free and will help reduce the value of your estate for IHT purposes.
HOW TO IMPROVE THE PORTFOLIO
James Norrington says:
You have the capacity to take risk, but nasty bear markets can undergo falls of more than your 20 per cent loss limit. The internationally diverse nature of your portfolio is not necessarily protection against the worst falls in stock markets if correlations between countries' indices rise in a period of crisis, such as they did in 2008-09.
So your aim of diversifying across asset classes is sensible and you are already doing quite well on this. The DB pension can be considered as a safe fixed-income-style portion of your wealth, albeit with an income earmarked for the future, and your properties also provide an element of diversification.
Your plan to build up a cash reserve is sensible as it will give you an easily accessible fund for emergencies. The cost of doing this is the erosion of the value of cash thanks to inflation. If you fix the interest rate, however, the mortgage on your London home is a natural hedge against inflation. Although the purchasing power of your money will fall in an inflationary environment, so will the real value of the sum you owe.
The prices of many bonds are sky high thanks to years of ultra-loose monetary policy and quantitative easing by central banks, and as interest rates are rising they will fall. This causes capital losses for bond funds, especially those with a longer average duration. This is the time in years to the effective maturity of bonds at the required rate of return, which is a measure of the sensitivity of bond prices to interest rates.
And many higher-yielding bond funds have invested in riskier corporate and emerging market debt, due to the cost of high-quality government and corporate paper in recent years. These funds' holdings have a greater risk of default in a recession, a potential scenario due to the international tariff disputes. A recession would also be bad for equities and, if you have two asset classes that face the same risks, they probably won't offer divergent returns in a bad period.
Lower duration, high-quality government bonds such as UK gilts or US Treasuries could, however, be expected to behave differently to equities in a sell-off. This is particularly the case with US Treasuries, which offer an almost unwarranted yield spread over comparable debt such as German Bunds and could make capital gains if there is a flight to quality.
As you are a higher-rate taxpayer your reason for diversifying holdings is capital preservation rather than income, so the lower yields on safer debt should be less of a concern.
Peter Savage says:
In extreme market falls, your portfolio could fall more than the 20 per cent you say is the most you could tolerate. So you are right to try to make the portfolio more stable.
Traditionally, you invested in fixed interest to reduce the volatility and risk in a portfolio. But as interest rates are expected to rise fixed interest yields are likely to increase and capital values are likely to reduce. So consider short-dated bonds, which are less susceptible to interest rate duration, and increasing your allocation to property and commodity indices as these have typically not been correlated with equities.