Join our community of smart investors

Make asset allocation a conscious decision

Choosing shares and funds is easier once you know how much you want in risky and safe holdings
August 9, 2018, Austin Broad and Kay Ingram

Nigel is 66 and widowed. He has two French stepchildren in their mid-40s, one of whom lives in London and one who lives in France, where he is considering moving. He receives the UK state pension, a small NHS pension and half his late wife's French government pension, in total about £2,000 a month.

Reader Portfolio
Nigel 66
Description

Sipp invested in funds, cash, UK and French residential property

Objectives

Total return of 5 per cent a year, take income of 3 per cent a year

Portfolio type
Managing pension drawdown

Nigel's home is worth about £550,000 and mortgage free. He and his late wife bought three flats in Paris and he and his stepchildren have recently sold one of these. They are selling another and Nigel should get about €130,000 (£115,772) from the sale.

"My pensions cover most of my expenditure with the exception of large purchases so I don't expect to have to liquidate chunks of my investment portfolio at short notice," says Nigel. "I have taken my 25 per cent tax-free cash sum from my pensions, and hold most of it in my individual savings account (Isa) and trading account as cash, but I have not drawn down anything else from it. I also intend to hold cash outside my self-invested personal pension (Sipp) so I will not have to curtail my normal expenditure if markets take a steep dive. 

"I may live for another 20 to 30 years or longer, and plan to leave the majority of my assets to my stepchildren or their children. So I am looking to invest for the long term and think it makes sense to have most or all of my Sipp in equities. 

"I would like to make a total return of 5 per cent a year if I can do it without too much risk. I do not plan to take an income from it of more than 3 per cent a year – at least for the first few years of drawdown.

"I tend to take a buy-and-hold strategy but last November I thought the market was getting a bit toppy so I liquidated holdings worth about 60 per cent of the value of my Sipp. "But I think it's time to start investing again, so wondered what areas I should allocate to, and whether I should focus on growth or income funds.

"I don't normally invest directly in shares but my brother suggested I take a punt on Hardide (HDD). Its initial volatility tested my patience reinforcing my preference for investing via collective funds.

"I have been investing on and off for about 40 years, but it's only since I starting my Sipp in 2014 that I've taken a proper interest in my pension. I used an investment manager until late 2016 but left them because they wanted to make substantial changes to my portfolio. I didn’t see the point of incurring needless costs when the existing investments seemed to be performing quite well, and they wouldn't consider investment trusts."

 

Nigel's portfolio

HoldingValue (£)% of portfolio
Fundsmith Equity (GB00B41YBW71)35,4003.74
Hardide (HDD)1,1000.12
Aberdeen Asia Pacific Equity (GB00B88N7058)11,5001.21
JPMorgan Emerging Markets (GB00B1YX4S73)12,3001.3
First State Global Listed Infrastructure (GB00B24HJL45)6,1000.64
Aberdeen Japan Equity (GB0004521737)19,5002.06
Schroder Global Cities Real Estate (GB00B1VPTY75)8,8000.93
UK residential property550,00058.08
French residential property61,4046.48
Cash188,37619.89
Cash (euros)52,5055.54
Total946,985 

 

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're right to assume a fairly low safe run-down rate for your pension. There is a distinct risk that long-term equity returns will fall short of the 5 per cent average we consider normal and interest rates are very likely to stay well below historic norms. So taking 4 per cent of your wealth each year as income might result in a drop in its value, especially in bear markets.

You're happy to have most of your Sipp in equities but at the moment most of it is in cash. In the short term this may be no bad thing. Most lead indicators point to equity returns being either average or worse, for example, the dividend yield, foreign buying of US equities, the global price-to-money ratio, the ratio of Aim shares to the FTSE 100 index and the ratio of retail sales to the FTSE All-Share index. This suggests there's no rush to get into the market, and perhaps a reason to stay out.

But there's a mistake you should try to avoid. 

The first thing you must consider as an investor is how you should split your wealth between risky and safe assets. Only then do you consider what specific stocks or funds to buy. The danger, however, is that you end up holding too much cash because you can't decide what to buy or too little because so many things look good.

This isn't always a bad thing: a lack of attractive looking funds or shares might be evidence that the general market is overpriced. But your asset allocation should be the result of a conscious decision, not the outcome of a selection of investments you fancied buying.

One way to avoid this mistake is to think of a global tracker fund as your default equity investment. If you want to hold shares but don't know which ones to invest in, put the money into a global tracker fund until you have a better idea. When you decide to move out of cash, do this.

Another issue is what sort of cash you should hold. Your euro deposits might be wise. They offer protection against the risk of a nasty form of Brexit, as what's bad for the UK economy might also be bad for sterling and good for the euro. More generally, there has been a tendency in the past for the euro to sometimes do well when equities and UK house prices do badly, implying it has some value as a hedge against losses on other assets.

But a Sipp is not a good place to hold cash because the rates on many Sipp accounts are even worse than they are on other cash deposits.

You are right to avoid bonds. These might do well in some of the conditions that shares do badly but this insurance comes at a high price – the risk of falls when US and UK interest rates rise. And your euro cash is already providing some insurance.

 

Austin Broad, group head of advice at AFH Wealth Management, says:

Although your State and NHS pensions benefit from index-linking, inflation appears to be your main risk. A 5 per cent annual return would give you a return over inflation at present. But as economies and markets change against a backdrop of potentially rising interest rates and inflation, it would make sense to try to review your growth target to ensure that real growth is achieved with reference to a measure of inflation such as the consumer prices index (CPI).

Most of your Sipp, Isa and trading account are invested in cash, and you also have cash accounts denominated in sterling and euros. After the sale of your French property you should work out how much cash you need to meet future liquidity requirements and capital expenditure.

If you are going to live in the UK you need to consider the value of keeping cash and other assets denominated in euros. Fluctuations between sterling and the euro could affect the value of any euros when converted to sterling, so you may find it more straightforward to have all your cash denominated in sterling so you can repatriate your funds at the most appropriate time.

Your capital expenditure requirements will determine your future financial requirements. For example, are you going to invest in property again in the UK or France?

When you know what capital is available to you, and what tax or other costs may be deducted from this, you will be able to address your portfolio strategy. It would probably not be sensible to draw funds from your Sipp until you are age 75 as the money in it is outside of your estate for inheritance tax (IHT) purposes. Unless you have any excessive capital expenditure requirements, for the next nine years take capital or income from the assets that fall within your estate.

Not having to take income from your pension also means you have greater freedom in terms of what you invest it in, as you do not have to target investments to meet a certain level of yield.

Are your step-children formally adopted? If not, under current IHT legislation the whole value of your residential property will be counted as part of your estate. This would increase the importance of maintaining your pension fund.

If you live in the UK it is important to fully use your annual Isa allowance, currently £20,000 a year. It would also make sense to invest your Isa in investments rather than cash which offers low rates of interest. You have personal savings allowance of £1,000 if your total taxable income does not exceed the higher-rate threshold, which should allow you to hold cash worth at least £40,000 outside an Isa without incurring tax.

An income of 4 per cent a year from your portfolio would probably require changing its asset allocation. An income of 3 per cent a year is a healthier level from an investment perspective. 

It is essential that the nomination form for your Sipp is reviewed to ensure that its contents reflect your wishes in terms of passing on your assets to your step-children and their children after you die. This is because assets in the pension are unlikely to be dealt with under the terms of your will.

 

Kay Ingram, chartered financial planner at LEBC, says:

At age 66 you are wise to invest for your long-term needs and invest most of your Sipp in growth assets.  A 5 per cent return and a withdrawal rate of 3 per cent are achievable if you are willing to take a medium to high level of risk. Your regular outgoings are covered by income from your pensions, and the NHS and State pensions provide protection against inflation.

As you only need your Sipp for discretionary spending requirements you could leave it to grow until you are older.

When you have disposed of a second French property you will have a substantial amount of cash. As interest rates remain low, having a high allocation to this asset is not a good idea as it will not keep pace with inflation. Paying off your credit card debt of £5,500 should be a priority.

To simplify your affairs, consolidate your various French accounts into one and retain a euro float to cover your costs when you are in that country.

Some of your UK current account regular savings are paying you 5 per cent interest. But interest rates are often fixed for 12 months after which they fall to almost nothing. Your discretionary spending fund should be invested in a deposit account – basic-rate taxpayers can earn £1,000 in interest each year tax-free outside of Isas. Switch your cash Isa to a stocks and shares Isa which has the potential to produce higher returns. You can add £20,000 per tax year to this which will provide tax-free income and growth.

Until you are 75 you can continue to pay into your Sipp. As you are not earning the amount is limited to £2,880 per tax year, to which HM Revenue & Customs adds £720. So, over the next nine years your Sipp could grow by £32,400 and cost you just £25,920.

 

HOW TO IMPROVE THE PORTFOLIO

Austin Broad says:

The asset allocation of your portfolio doesn't seem to have any particular logic.

Your desire to avoid bonds is understandable as rising interest rates could result in capital losses and illiquidity for them, with the exception of those with the shortest durations. But when interest rates and inflation reach the pinnacle of their cycle it may be sensible to reconsider bonds because of their non-correlated diversification benefits.

It would be sensible to consider using investment trusts when you invest your cash, though these can gear (take on debt). But there can be opportunities to buy their shares at a discount to their net asset value, and their managers don't have to factor inflows and outflows of investor money into their investment strategies.

The concern caused by your small investment in Hardide raises the issue of what level of loss you could tolerate. Investing in collective funds should help to moderate volatility.

If you take income from your portfolio consider holding as much as six to 12 month's income in cash. This would help maintain your level of income if there is a market correction [without having to draw on your investments]. 

You could also reallocate the portfolio to investments that generate an income, but if there is a market correction the income they pay could be negatively impacted – as well as their capital value.

Consider investing in a commercial property fund that would have a low correlation with equities and offer a healthy yield that could supplement your portfolio's income.

Also consider outsourcing the management of your portfolio to a discretionary investment manager. This would prevent you from selling out of assets you should hold for the long term due to concerns on the short-term vagaries of the market. Your portfolio would also be run via a more disciplined and bespoke strategy. But it would incur an additional cost.

 

Kay Ingram says:

If you earmark some of your cash to cover discretionary spending and capital items, over say the next three to five years, so that you do not withdraw from your Sipp, it will provide an insurance against short-term market downturns.

Equities give you the best chance of achieving long-term growth. But invest your Sipp in other assets, too. This is a long-term investment, and diversifying it with commercial property and fixed interest will give it a better chance of achieving your goals in all market conditions.

Investing in multi-asset collective funds that have a 5 per cent overall target return would mean you don't have to worry about timing when you invest. Your 'wobble' last November is likely to have lost you money: markets took a dip in the early part of 2018 but have since recovered. Market timing is difficult to get right, and when you sell out you miss out on dividends and incur dealing costs.