Use all the tax breaks available to you

"My public sector final-salary pension is worth about £1.32m,” says Andy. “I applied for individual protection 2014 when the lifetime limit was £1.5m and was able to protect about £1.3m. I have opted out of the pension scheme with regard to my main job, and increased my income and tax accordingly. However, I have now taken a part-time role with another organisation for a salary via which I make a very small contribution to the same public sector pension scheme. This means that my wife could still benefit from the scheme's life assurance. However, the pension is still growing and presents me with a tax problem when I retire at 60.

“I have recently received estimates stating that with my current total at retirement I could either take a: 

- tax-free lump sum of £327,000 and annual income of £49,000.

- tax free lump sum of £182,000 and annual income of £61,000

"I am not allowed to transfer out beyond this.

"My wife has been paying into her pension for 22 years.

"I have a large public sector pension and I don’t have any big life events to plan for, but it would still be great to beat the market with my investments. Eventually the assets will pass to our children. In the meantime I want to enjoy managing the investments, aiming for growth but reducing the risk of capital depreciation via diversification. 

"I have been investing for 12 years and can tolerate high levels of risk because my pension is secure, but I would be gutted if my stocks were clobbered in a bear market.

"I set aside money to invest regularly so it is essential to budget. I have found the MoneyWiz app invaluable in helping me to do this.

"In terms of how I invest, I have been heavily influenced by a book called How to Own the World by Andrew Craig, and other books I have found helpful include The Naked Trader by Robbie Burns, The Richest Man in Babylon by George Samuel Clason and The Undercover Economist by Tim Harford.

"I divide my portfolio into three equal segments which I call ‘work’, ‘rest’ and ‘play’.

"The work segment tends to be focused on overseas equities mainly accessed via exchange traded funds (ETFs). There is some overlap between the funds in this segment but I am happy to increase my exposure in these areas. I recently sold iShares Edge MSCI World Momentum Factor UCITS ETF (IWFM) and bought Xtrackers MSCI World Quality UCITS ETF (XDEQ) on the basis that lower debt companies should fare better in a downturn. I am also thinking of investing in India Capital Growth Fund (IGC) and other emerging market funds.

"The aim of the rest segment investments is to provide diversity and not track market indices closely in a downturn. But I have relatively low exposure to bonds because my public sector pension is essentially a bond – a UK government promise to pay.

"I enjoy stock picking, although acknowledge that I do not have a special edge even though I have done well in the past 10 years. So I limit the play segment to approximately about one-third of the value of the investment portfolio. Recent investments in this section include Crystal Amber Fund (CRS).

"I try to constantly rebalance the investment portfolio by putting new savings into the areas that need a leg up – usually the ones in the rest segment. I also want to keep my portfolio fairly simple so tend to have less than 20 holdings."

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:

Your view that your public sector pension is like a bond holding is very right - anybody with a defined benefit pension is, in effect, a big holder of bonds. So, in principle, this could allow you to take more risks than the average investor. You are doing this to only a moderate extent, however.

You say you'd be “gutted” if your investments were clobbered by a bear market but you might be pleasantly surprised here. Just before the 2008 crisis, Christoph Merkle, associate professor of finance at Kuehne Logistics University asked UK investors how they would feel if they made big losses. Most replied along your lines. But when he surveyed them again after they’d actually experienced those losses, he found them to be in better spirits than they expected. Losses hurt us less than we expect.

I suspect that one reason for this is because in a bear market we can comfort ourselves with the thought that we’re all in the same boat. So perhaps it is idiosyncratic losses that hurt instead – those we suffer when a position we take, that others have not taken, goes wrong. So are you resilient to this sort of loss?

Matthew Baines, chartered financial planner at Beckett Financial Services, says: 

By applying for Individual Protection 2014 you have protected the vast majority of your pension from a lifetime allowance tax charge and, based on the details provided, the excess liable to a lifetime allowance charge will be relatively small. Your pension value has moved from £1.3m to £1.32m between 2014 and 2018, so it would appear that you will have a relatively small excess over and above your Individual Protection 14 limit of £1.3m.  If you take this as income the tax charge will be 25 per cent in addition to your marginal rate of tax.

Without knowing what the value of the death benefits are, and how much your and your employer's contributions are, it is difficult to say whether it is worthwhile continuing to be an active member of the scheme. If the employer contributions make up the majority of the funding and the death benefits are valuable when compared to taking out a separate personal policy, then incurring this additional tax charge may still be cost effective.

Your options are to take a £182,000 tax free lump sum and £61,000 a year income, or a £327,000 lump sum and £49,000 a year income. In both scenarios you will be a higher rate tax payer with £61,000 a year providing you with net income of £4,020 per month based on today’s tax bands. £49,000 a year will provide you with net income of £3,420 per month.

If you take the higher lump sum, the additional £145,000 would very crudely cover 20 years of the £7,200 lost net income. This doesn’t allow for the indexation of the excess income on the higher amount which would stretch the gap between the two incomes over time. But probably more significantly it doesn’t allow for the return you may be able to generate on the additional £145,000 if you take the higher lump sum. Your income position is already likely to be strong with a state pension entitlement of £8,546.20, and the state and occupational pension income your wife will receive.  Based on your guaranteed income position and without knowing your retirement plans, I generally suggest maximising the tax free lump sum.

Because of your tax position it is very important to consider using all the tax breaks available to you. You don’t say whether your investment portfolio is held in individual savings accounts (Isas). You and your wife can each put £20,000 into Isas a year, which would be sheltered from capital gains and income tax. Another area you could consider now and in retirement is Enterprise Investment Schemes (EIS) and Venture Capital Trusts (VCTs). 

Your portfolio is very aggressive and you manage this personally, suggesting you are comfortable with a higher level of risk. But I am slightly concerned that you would be ‘gutted' if your stocks were clobbered. Your portfolio is structured for high growth potential but its downside risk is also significant. You are an additional rate tax payer who will be a higher rate tax payer in retirement so if you are comfortable with a relatively high level of risk, VCTs and EISs could improve your tax position significantly - especially as you can no longer do this with pensions.

EIS offer income tax relief at 30 per cent on contributions, are free from CGT, any loss on the investments can be offset against income tax and the investments are free from inheritance tax (IHT), subject to certain conditions. Seed EIS offer even more attractive tax benefits but are very high risk. 

VCTs also offer tax relief at 30 per cent on contributions and are free from CGT on disposal. They don't qualify for IHT relief but are great for boosting income in a tax efficient manner. Your dividend allowance is now only £2,000 but VCTs offer tax free dividend income. So for a higher rate tax payer they could be a way to boost income in retirement – especially if you take the higher lump sum and lower income.

From a diversity perspective your portfolio is more concentrated than we would generally recommend.  We would tend to hold 15 to 20 managed funds for our clients, and each fund on average has 40 to 60 holdings. Our most adventurous portfolio is more concentrated with eight funds but is for clients with a time horizon of 15 years plus. It is important you accept the risks associated with your portfolio - especially as you have a relatively light cash allocation in proportion to the rest of it. 

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

The division of your portfolio into work, rest and play is a neat idea. It’s similar to the more common split between a core (diversified funds) and satellite (specific plays) approach, except that your core is smaller than many other investors’ would be.

One concern I have is how well the rest segment of your investment portfolio would protect you from a downturn. Gold should hold up in the event of anything that reduces share prices and bond yields such as a recession. I’m not sure, though, that it would do so well if equities were to fall because of rising interest rates. Higher rates are usually bad for gold because, in effect, they make it more expensive to hold as you are foregoing more income from cash if you hold gold instead.

I’m also not sure how well your investment trusts would hold up in a downturn. Almost all equity assets tend to fall to some extent when the market falls. This might be especially true of investment trusts which are currently on premiums to net asset value. Discounts and premiums are signs of investor sentiment but this of course falls in bear markets. And in a really nasty bear market investors flock into liquid assets – those that can be easily sold. Because infrastructure assets are illiquid such a situation might be detrimental to this kind of funds.

I also have doubts about your play portfolio, although I would praise you for not over diversifying it. One issue is that it is prodigiously hard to spot future growth. Investors have traditionally paid too much on average for stocks which appear to offer it. In this context, there are two things you should consider which might help improve your chances.

One is what moats – a competitive advantage that one company has over other companies in the same industry – does a given company have? What has it got that will enable it to fend off competition? Profits do not come merely from good ideas and products: these can be copied. They come from some degree of monopoly power.

And can the given firm grow without hurting profits? Is it scaleable? Investors have often under appreciated the extent to which growth reduces asset turnover or profit margins, for example, because managers focusing on growth take their eye off cost control or pursue low-margin sales. Watch out for companies that do this.

I think its reasonable to have emerging market equities on your list of potential investments as there’ll come a time when these are cheap. But perhaps not yet. History tells us that such assets are momentum-prone, and that the time to buy them is when they’ve risen above their 200-day moving average.

Jason Witcombe, chartered financial planner at Progeny Wealth, says:

Investors should blend defensive assets with growth assets to get the most appropriate balance between risk and reward. The best mix will consider the emotional aspects of investing, for example, how adventurous or cautious someone is, as well as the financial aspects such as how much risk they need to take and how much they can afford to lose.

Looking at your overall financial position, I understand why your portfolio is predominantly in equities.  You have a high capacity for loss given the financial security your public sector pension gives you. Even if your portfolio suffered significant falls, which it will from time to time given the very high risk nature of many of your holdings, this should have little impact on your standard of living. Your timescale is long and you can afford to ride out the inevitable ups and downs.

Investing is a hobby for you and because of this you have a very active approach. Most of your holdings are very specialist in nature so carry significant risk. It also means your investment portfolio lacks genuine diversification because not much is invested in the most diversified funds. That is your personal choice but I would urge caution around the enjoyment aspect of investing, particularly as the amounts invested increase. A high risk, highly concentrated investment strategy often seems more exciting than the alternatives but that doesn’t mean it’s right.

The more specialist and active a portfolio is, the less important costs might seem, but diversification and costs are two key aspects of investing that we can control. I expect you would be shocked if you were able to quantify and see the overall management cost of your portfolio. For example, one fund in your portfolio is quoting running costs in excess of 3.5 per cent a year. With charges at this level, the main winners are likely to be the fund managers rather than you.

As an alternative, a global equity tracker such as Vanguard FTSE Developed World ex-U.K. Equity Index Fund (GB00B59G4Q73) gives you access to over 2,000 individual companies, spanning multiple countries and sectors, for just 0.15 per cent a year. That’s not as exciting but it gives much better diversification at a fraction of the cost.

I’m not convinced that there is much of a difference between your rest and play portfolios in terms of diversification and risk/reward. I wonder if the portfolio could be simplified into a more straightforward core and satellite approach? The majority of the portfolio could be in the core part, invested in very low cost, well diversified, mainstream funds. And the satellite part could include the higher cost, more speculative funds that interest you.

Geographic breakdown as at 31 October 2018 (%)

Source: Vanguard