Join our community of smart investors

Determine the level of retirement income you require

Our readers have little in the way of pension provision and must shape their portfolio to cover their costs
January 17, 2019, Patrick Connolly and Jason Porter

Clive is 65, and lives in the United Arab Emirates where he is in full-time employment and tax resident. He and his wife, who is 63, have lived abroad since 1982, but want to retire in the UK. Clive has little formal pension provision: he receives a workplace pension of £1,500 a year, although this is index-linked. And Clive and his wife's National Insurance contributions should entitle him to a UK state pension of about £7,000 a year and her to one of about £8,000 a year.

Reader Portfolio
Clive and his wife 65 and 63
Description

Funds, some of which are in an Isa, cash, residential property

Objectives

Portfolio large enough to finance comfortable retirement from April 2019, holidays and possible care costs

Portfolio type
Investing for income

“Our prosperity during retirement will depend on the investment portfolio that we have built up," says Clive. "So our objective is to have a well-structured investment portfolio that is large enough to provide a comfortable retirement, fund holidays and, if necessary, cover care costs in later years. If the value of our investments is sufficient to meet our objectives with a margin of safety for market downturns, I would like to retire this April.

"I wondered what is a reasonable withdrawal rate for someone who largely lives off their investment portfolio? We have no children, so have structured our wills to pass on any remaining assets after our deaths to friends and charities.

"Would British winters be a nice novelty or a misery you will want to escape via long holidays?

"For reasons of tax efficiency, most of our investment portfolio is held in my name with a smaller portion in my wife’s individual savings account (Isa) as her tax status is different. But when I am UK resident we will split the investment portfolio equally between us so we can both benefit from our personal tax allowances for pension income, dividends and capital gains. I will invest the maximum amount possible each year into an Isa, and my wife will increase her contributions so that she does this too.

"We own a UK residential property worth about £800,000 with no mortgage. I assume this asset could provide some safety in bad market conditions or fund care costs in later years, if necessary.

"Our allocation to cash is much higher than usual because I am selling the investments on which I have made a capital gain prior to becoming UK tax resident after the end of the current tax year. And I have largely held back from investing money over the past year because cyclically adjusted price/earnings (CAPE) ratios are at similar levels to in 2000 and 2007, and many previous bull runs have ended when the US central bank, the Federal Reserve, has increased interest rates.

"When I am retired I may hold cash worth two years' pension income. Although interest rates are at historic lows, I think bonds are risky, particularly long-dated ones. In times of severe market downturns I will refrain from selling investments to cover living costs, and draw down my cash and any other low-risk holdings.

"I mostly select funds I think could achieve the highest regular returns over longer-term periods of five to 10 years, while limiting volatility and downside risk. I like, where possible, to see what the performance of a fund’s manager was like during particularly bad downturns such as 2007 to 2009, and how long they took to recover to where their position was before the losses.

"I tend to limit my allocation to investments that do not have such a record and higher-risk ones, as I am aware that it is difficult to claw back investment losses. For example, I have recently sold a holding worth £153,000 in Murray International Trust (MYI) because I am concerned about the possible effect of a rise in the US dollar on dollar-denominated debt in Asia and Latin America.

"I also like to own funds in which the manager has some of his or her own money invested.

"If the value of our overall investment portfolio falls by more 25 per cent I would like it to recover to its original position within four years.

"As we grow older we will need to reduce the risk and volatility of our portfolio, so wondered what type of asset allocation would be suitable for when we are in our later years, and roughly at what age we should move to it.

"I have been investing for 25 years and my approach has been influenced by investors such as Nick Train, Michael Lindsell and Terry Smith, whose funds I have a significant allocation to. I have also read The Craft of Investing by John Train, and been influenced by Warren Buffett, Joel Greenblatt, Richard Watts and various managers of RIT Capital Partners (RCP) – the investment I have held the longest. This is focused on capital preservation, but still provides reasonable long-term growth and gives exposure to investments that are not directly available to private investors. I will consider adding to this trust if its premium to net asset value (NAV) reduces.

"I am also thinking of adding to Witan Investment Trust (WTAN), and investing in BMO Global Smaller Companies (BGSC) and Scottish Mortgage Investment Trust (SMT) – if its share price comes down.

 

Clive and his wife's portfolio

HoldingValue (£) % of the portfolio
Jupiter European (GB00B4NVSH01)310,9119.71
Fundsmith Equity (GB00B41YBW71)288,9439.03
RIT Capital Partners (RCP)274,2968.57
Stewart Investors Asia Pacific Leaders (GB0033874214)190,0835.94
Lindsell Train Global Equity (IE00BJSPMJ28)141,1454.41
LF Woodford Equity Income (GB00BLRZQB71)121,0073.78
Merian UK Mid Cap (GB00B1XG9482)92,1872.88
Finsbury Growth & Income Trust (FGT)70,7992.21
Perpetual Income and Growth Investment Trust (PLI)64,6392.02
LF Lindsell Train UK Equity (GB00BJFLM156)62,7631.96
Worldwide Healthcare Trust (WWH)62,4491.95
Bankers Investment Trust (BNKR)36,5321.14
First State Global Listed Infrastructure (GB00B24HK556)25,3790.79
Jupiter Asian Income (GB00BZ2YMT70)19,7640.62
Artemis Global Income (GB00B5ZX1M70)14,3840.45
City of London Investment Trust (CTY)10,8890.34
Liontrust Special Situations (GB00B57H4F11)10,8840.34
Witan Investment Trust (WTAN)9,0650.28
Troy Trojan (GB0034243732)5,0250.16
Wife's Isa75,0002.34
Residential property800,00024.99
Cash515,00016.09
Total3,201,144 

 

NONE OF THE COMMENTARY BELOW SHOULD BE REGARDED AS ADVICE. IT IS GENERAL INFORMATION BASED ON A SNAPSHOT OF THESE READERS' CIRCUMSTANCES.

 

THE BIG PICTURE

Chris Dillow, Investors Chronicle's economist, says:

I suspect most of your assumptions about a sustainable withdrawal rate are on the cautious side. A reasonably cautious assumption for total returns on a portfolio, 75 per cent of which is in equities and 25 per cent of which is in cash, is around 3 per cent a year after inflation – over £70,000 a year for your portfolio. So you could reasonably expect to take out 3 per cent a year while leaving capital intact and only market falls would reduce your wealth over time – although these should be cancelled out by recoveries.

And two things might make your position even more comfortable than this. One is the extent to which you are willing to run down your wealth so, in effect, reduce the bequests you leave to friends and charities.

The other is how you regard your house. If you’re willing to trade down later in life your house is an investment asset and you can regard it as a way of diversifying equity losses – albeit an imperfect one as a recession would depress house prices as well.

But there’s one crucial issue you haven’t mentioned: how much you hope to spend. Having spent so long abroad, I suspect there’s added uncertainty about this. For example, would British winters be a nice novelty or a misery you will want to escape via long holidays? Without knowing your spending requirements we can’t say how much risk you need to take on.

 

Patrick Connolly, chartered financial planner at Chase de Vere, says:

You are adopting a very sensible and pragmatic approach, and have given a great deal of thought to your investment portfolio and overall finances. You have taken tax advice, which is essential when moving back to the UK, and you are aware that you and your wife should use various tax allowances such as Isas, when back in the UK.

Before delving too deeply into your finances you need to define your financial goals. The starting point is to determine what level of income you will require in retirement. If you don’t know this you cannot work out whether your retirement plans are realistic.

Ideally, you will have guaranteed or secure income, which is protected whatever happens to markets to cover basic living costs in retirement. For many people this comes from a combination of state pension, defined-benefit pensions and lifetime annuities. However, due to living abroad, you have a limited amount of pension income. So consider the role that annuities could play because, although rates may seem relatively low for a 65- and 63-year-old, they provide an income that lasts a lifetime. You and your wife also have no children to pass assets to.

You have given some thought to withdrawal rates from your portfolio and included a sensible stress test. Cash flow analysis can play an important role in helping to ensure you don't take too much or too little income in retirement. If you are taking too much income you risk paying unnecessary tax charges in the short term and running out of money in the longer term.

However, cash flow analysis is based on a series of assumptions, which will invariably be wrong. For example, I would question whether inflation will be 4 per cent a year – even if sterling weakens further. And general industry consensus is that 4 per cent a year is a safe level of income to withdraw, but this isn’t necessarily the case. With a 4 per cent withdrawal rate your money could run out while you and your wife are still alive.

Rather than using cash flow analysis as a one-off calculation to determine the maximum level of income that can be withdrawn, you should focus on how much income you need and determine whether this looks viable. You should then review this every year and, if necessary, make changes to your portfolio and withdrawal rate to ensure your retirement plans remain on track.

These decisions are too important to get wrong, so consider getting independent financial advice to help ensure that your income requirements can be met on an ongoing basis.

You suggest using your property as a safeguard against poor market conditions or future care costs. This can work, but there may be problems if one of you goes into care and the other remains in the property. Would the person in the property be prepared to consider equity release, whereby the full value of the property isn’t be realised, or selling it and moving to a cheaper property to free up money?

 

Jason Porter, director of specialist expatriate advisory firm Blevins Franks, says: 

You say you have a relatively high capacity for loss, so could withstand a 25 per cent loss that you don't recover for four years. But your impending retirement may require a rethink of both your capacity for loss and attitude to risk. This would be a prudent time to think about de-risking the portfolio and whether the main focus should still be long-term growth or capital preservation.

You could diversify your investment portfolio's asset allocation. As some investors approach retirement, they adopt a life-styling strategy, whereby they begin to sell down some of the equity content so they can reinvest in fixed income and decrease the risk in the portfolio. While we would not advocate doing this in all market conditions, increasing your allocation to fixed income or other defensive assets like infrastructure or real estate investment trusts (Reits) could help to decrease the volatility of the portfolio in retirement. This could help to make your retirement more comfortable because you wouldn't need to base your spending habits on whether equity markets are in a bull or bear run.

As your retirement and financial situation is changing, this is a good moment to re-examine your attitude to risk, income needs and capacity for loss, and see how this ties in with your current asset allocation.

 

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

Your portfolio might not be as well diversified as you think because your funds hold some of the same stocks as each other. For example, Finsbury Growth & Income Trust's (FGT) three largest holdings are Diageo (DGE), RELX (REL) and Unilever (ULVR), which are also LF Lindsell Train UK Equity Fund's (GB00BJFLM156) three biggest holdings. Jupiter European (GB00B4NVSH01) and Fundsmith Equity (GB00B41YBW71) both have big investments in Amadeus (NL:MCE). And Lindsell Train Global Equity (IE00BJSPMJ28) and Fundsmith Equity both have a big holding in Paypal (US:PYPL)

This is maybe because great minds think alike. History tells us that defensive stocks with sources of monopoly power such as big brands or barriers to entry have outperformed for years, so good fund managers hold them. But because there are only a few such stocks these managers end up with holdings in common.

This exposes you to the risk that investors have wised up to the merits of such stocks, meaning they are now be overpriced. Apple’s (US:AAPL) big fall since the autumn reminds us that investors can pay too much for even the strongest companies with the most powerful brands.

In this sense, there’s an underappreciated paradox about fund managers’ track records. A good record isn’t just a sign that a manager has done well. It might also indicate that investors have learned about their strategy and jumped on the bandwagon, driving up the prices of the shares such managers hold too far.

There’s a precedent for this. In the 1980s investors realised that small stocks had outperformed for years and funds invested in them had done well. So they piled into them and by the late 1980s small-caps were so overpriced that they underperformed for the next 10 years.

You are not as exposed to this danger as you could be, but it is a potential problem you might want to reduce your exposure to. Also remember that passive global tracker funds are a cheap and easy way to spread equity risk.

 

Patrick Connolly says:

It is particularly good that you review the performance of fund managers in both good and bad times. As a result, you hold a range of good quality investment trusts and funds.

However, your investment portfolio is almost entirely allocated to equities and, even though you have some excellent defensive funds and a high level of cash, this is still a high-risk approach. Your focus on equities may have rewarded you in the past, but if you are going to rely on your portfolio to generate income you need to diversify risk better. Your own analysis shows the huge impact that a 25 per cent drawdown rate could have on your income projections.

You are right to keep money in cash to cover income requirements for an initial period and/or to prevent having to sell assets when there is a market collapse. However, you can also guard against this via your asset allocation, by investing in fixed-interest, property and absolute-return funds – as well as equities.

Equity investments can generate income, including some of your existing holdings, such as Perpetual Income and Growth Investment Trust (PLI), LF Woodford Equity Income (GB00BLRZQB71) and Artemis Global Income (GB00B5ZX1M70).

You could also retain some growth-orientated holdings, including RIT Capital Partners, Liontrust Special Situations (GB00B57H4F11), Fundsmith Equity and Witan Investment Trust. Although these do not provide a high level of income, any shortfall could be made up with capital or cash withdrawals from the wider portfolio.

You don’t need specialist investments such as Worldwide Healthcare Trust (WWH), and I'd suggest that no holding accounts for less than 1 per cent to 2 per cent of your investment portfolio.

There are a number of risks with fixed-interest and we share your concerns about certain long-dated bonds as these could come under pressure. I would suggest using flexible strategic bond funds run by experienced fund managers, for example Jupiter Strategic Bond (GB00BN8T5596), Janus Henderson Strategic Bond (GB0007502080) and Invesco Tactical Bond (GB00B8N45V05).

Commercial property can also provide diversification and income. There are possible liquidity risks, especially with the UK's departure from the European Union on the horizon, so you should have a maximum allocation to these of 10 per cent of your investment portfolio. Funds we like include M&G Property Portfolio (GB00B89X8P64) and Janus Henderson UK Property (GB00BP46GG64).

 

Jason Porter says: 

Your investment portfolio is almost entirely in equity funds, or ones with a high allocation to equities. So it may be worthwhile retaining some of your cash to meet expenses in the first few years of retirement. A cash flow modelling exercise with a financial adviser could help to clarify how well this equity focused portfolio would hold up in a stress-test scenario and still meet your goals for an income in retirement.

A challenge of investing via global equity funds is tracking the underlying holdings and calculating the overall asset allocation of your portfolio. Although Nick Train, Michael Lindsell and Terry Smith have been very successful, each fund manager has their own style and bias, so it is important to acknowledge this when building your portfolio. For example, Lindsell Train Global Equity Fund has a higher than usual bias to the UK and Japan relative to other global equity funds, as these are two regions its managers know well.

Your investment portfolio has a considerable bias to UK and European equities, but little exposure to US and Japanese equities. Although the US is the world’s largest stock market and comprises over 50 per cent of the world market, only about 25 per cent of your investment portfolio is allocated to it. Over the last three years, the US market has been one of the primary drivers of global stock market returns so a significant underweight to it could have an impact on your returns. This underscores the importance of asset allocation and keeping tabs on each fund’s underlying investments.

Due to uncertainty on the UK's departure from the European Union it may also be appropriate to look at the UK bias in your investment portfolio. Its allocation of approximately 27 per cent to UK equities is not unusual for a UK-based investor but is significantly more than the 6 per cent weighting global stock indices have to them. We would always recommend holding your portfolio in the currency of your liabilities, but also ensuring that it is well-diversified across multiple asset classes, regions and currencies. This can help to mitigate the risk of isolated political or macroeconomic events such as Brexit that will not be as likely to hurt Asian or American stocks as much as British or European stocks. And when you take into account the effects that Brexit could have on Sterling and euro exchange rates, the case for diversification becomes even more important.

Also look to spread the manager risk of the investment portfolio. Over two thirds of the investment portfolio are invested in only five funds, some of whose returns are highly correlated to each other. Although we like the high conviction approach of managers of funds such as Fundsmith Equity, Lindsell Train Global Equity and Jupiter European (GB00B4NVSH01), if one of their styles falls out of favour it could lead to losses on your overall portfolio.