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Think long and hard before opting out of your NHS pension

Our reader might be underestimating the benefits of his current scheme
Think long and hard before opting out of your NHS pension

Ajay is 42, divorced and has a three-year-old daughter. He is an NHS manager and expects to earn at least £94,000 a year for the next three years.

Reader Portfolio
Ajay 42
Description

Isa and Sipp invested in cash and funds, cash, NHS pension

Objectives

4% to 5% average annual growth to build up assets large enough to pay out £12,000 a year starting in 15 years, buy home, pay school fees

Portfolio type
Investing for goals

“I plan to work beyond the age of 57, but in case I can’t, would like savings so I can sustain a modest lifestyle," says Ajay. "I would like an income equivalent to £12,000 a year today, so would like my investments to grow by 4 per cent to 5 per cent a year for the next 20 years.

"I want to invest the maximum amount possible each year into individual savings accounts (Isas), currently £20,000, using my savings and some of my income. And I also want to invest as much as possible in a self-invested personal pension (Sipp) to take advantage of government tax relief on pension contributions, which for me is 40 per cent.

"My NHS pension is scheduled to start paying out £15,000 a year between the ages of 67 and 70. While I am a member of the NHS pension scheme, if I die my ex-wife and daughter would get two times my income and both would benefit by a modest amount from my pension.

“But I can't access the funds in the NHS pension scheme until at least age 67, so I am thinking of opting out of it for around five years, and rejoining it just before I turn 50. During this time I would contribute £32,000 a year into a Sipp because I want to build up funds that I could access at age 57. I probably wouldn’t do this, but want the options of being able to pay off all or some of my mortgage using the pensions' 25 per cent tax-free entitlement, working part-time, or taking a year out and travelling.

"My capacity to enjoy life between ages 60 and 70 will be greater than between 70 and 80, so I would like to access some of my pension savings earlier. I am prepared to take on the greater risk that a Sipp entails relative to a public sector pension scheme.

"I have a substantial cash holding of about £770,000 because I intend to buy a home this year. I will use around £540,000-£640,000 of the cash and borrow as large a five-year fixed rate mortgage as possible. I want to use as little of my savings as possible to fund the property purchase, especially those in the Isa. 

"We may send our daughter to a private school for her secondary education because the state secondary schools in our area are not good. My ex-wife and I each invest £50 a month for our daughter into Vanguard LifeStrategy 80% Equity Fund (GB00B4PQW151). This is held in my name rather than a tax-efficient wrapper in case the money needs to be accessed before her 18th birthday. 

"I have been investing on and off for over 10 years and do not try to time the markets. I can tolerate volatility, and accept that my portfolio could fall in value by 20-30 per cent. My strategy is to create a diversified portfolio of property, equities and bonds, and hold them in perpetuity. I will take the income they generate and/or sell some of the capital each year to create an income after I stop working.

"I will always hold cash worth £20,000 to £30,000 to draw on in emergencies. I also want to keep a portion of my Isa in corporate bond and UK tracker funds, so I do not have to sell overseas equity investments when sterling is strong.

"I am trying to take a simple, low-cost approach by investing in passive funds, which I hold and forget. I think spending hundreds of hours researching and reading economic and financial news makes no difference. And I don’t believe that over 20 to 40 years even star fund managers will be able to beat the index – most of them will have retired before that time is up anyway.

"I have recently added Vanguard FTSE 100 UCITS ETF (VUKE) to the portfolio. I plan to put a further £20,000 into Vanguard FTSE 250 UCITS ETF (VMID), and invest £10,000 in Vanguard FTSE UK Equity Income Index (GB00B59G4H82) and £8,000 in iShares MSCI UK Small Cap UCITS ETF (CUKS).

"But I have made some small allocations to active funds to try to diversify away from broad indices. I have recently invested in Henderson Smaller Companies Investment Trust (HSL) and Woodford Patient Capital Trust (WPCT). And I am going to invest £5,000 in LF Lindsell Train UK Equity (GB00BJFLM156) and £4,000 in Marlborough Nano-Cap Growth (GB00BF2ZV048).

"Because sterling is weak and UK equities appear to offer great value I have favoured this market. In the next 12 months I plan to invest around £50,000 in equities. Unless the pound returns to an exchange rate against the dollar of about $1.40 I will probably put it into UK equities.

"But I may transfer some of the FTSE 100 exposure to a global tracker – especially if the FTSE 100 goes up. This is because I am not sure that all the mining, tobacco, commodities and fossil fuel companies will be as profitable in 20 to 30 years' time. And over the long term I would like at least 70 per cent of my investment portfolio to be in non-sterling assets. I would like to diversify away from the UK as I will own a residential property here, and my NHS pension and employment income are sterling-denominated.

"I would like to have a large allocation to the US, Europe and some Asian countries, so might start drip-feeding my Isa into multi-asset funds such as Vanguard LifeStrategy 80% Equity. But I am sceptical about China, India and emerging markets – why invest in countries where there is little or no rule of law? 

"So far I haven’t invested significant amounts in corporate bonds, and over the past year that has worked out well. But I am in two minds about how much I should allocate to corporate bonds going forwards. My inclination is to allocate 20-30 per cent of my Isa to them so might start drip-feeding it into Vanguard LifeStrategy 20% Equity (GB00B4NXY349). And I might allocate 10-20 per cent of my Sipp to corporate bonds."

 

Ajay's portfolio

HoldingValue (£)% of portfolio
Vanguard FTSE 100 UCITS ETF (VUKE)23,8772.88
Henderson Smaller Companies Investment Trust (HSL)6,9090.83
Law Debenture Corporation (LWDB)6,3090.76
Vanguard FTSE 250 UCITS ETF (VMID)5,7610.69
Vanguard Global Value Factor UCITS ETF (VVAL)4,0780.49
Legal & General Global Real Estate Dividend Index (GB00BYW7CN38) 39050.47
Woodford Patient Capital Trust (WPCT)3,3000.4
Edinburgh Investment Trust (EDIN)3,0330.37
HSBC MSCI World UCITS ETF (HMWO)9580.12
iShares £ Corp Bond 0-5yr UCITS ETF (IS15)9380.11
NS&I Premium Bonds50,0006.03
Cash720,00086.84
Total829,068 

 

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:

If you take out a big mortgage you will in effect have a geared position in both housing and equities. It might be reasonable to have this with equities because above average dividend yields point to reasonable longer-term returns, in so far as anything has predictive power.

Housing valuations, however, are still high. And given the UK’s poor long-term growth prospects, it is difficult to see what might generate good medium-term house price gains. Unless you manage to find an unusually underpriced property – which may be possible as the housing market is not micro-efficient – you should regard your house purchase as a consumption rather than an investment decision.

Your strategy of holding low-cost index trackers is absolutely right. It is difficult to resist the temptation to deviate from this given the thousands of funds on offer. But to strengthen your resolve, remember these few basic principles.

Your asset allocation process should progress from generalities to particulars, not vice versa. So first decide what split you want between the basic asset classes – equities, bonds and cash – and then consider how to best implement it.

Management fees compound horribly: an extra percentage point of charges on a £10,000 investment could easily amount to more than £2,500 over 15 years. So the bar for deciding whether an active fund is worth the cost should be set high.

Also, there are only a few proven ways of beating the market, such as quality defensive, momentum or value stocks, and there’s a danger that investors have wised up to these, so their good performance might not continue.

 

Andrea Sproates, head of Chase de Vere Medical, says:

Your NHS pension scheme provides a solid base for your retirement planning, and you have realistic goals.

Your focus is on retirement planning, but there are other factors that could impact significantly on your finances, for example your planned property purchase and the possibility of private education fees. 

You want to generate an income of £12,000 a year in today’s prices by the time you are between 57 and 60. If you were to take an income of 3 per cent a year from your portfolio, this would require a lump sum of £400,000. 

Think long and hard before opting out of the NHS pension scheme – even on a temporary basis. Do not underestimate the significant benefits of this pension scheme. With an income of £90,000 you would pay £12,150 a year into the NHS pension scheme, which would buy a guaranteed income of £1,667 a year. This would increase at consumer price index (CPI) inflation plus 1.5 per cent a year. This is incredibly generous compared with investing in a Sipp.

You seem to favour a Sipp because of the added flexibility, such as being able to access your benefits at an earlier age. However, your assumption that you cannot access your NHS pension until age 67 or later is incorrect. You can access it earlier, albeit with a penalty, which at age 57 is 42.2 per cent and age 60 is 33.7 per cent, assuming the state pension age remains 68. Compare the benefits of your NHS pension – even after any penalties – with the potential returns from a Sipp, especially as you may not even want to take an income between the ages of 57 and 60.

You need to take specialist independent financial advice before leaving the NHS pension scheme. It is possible that the best approach for achieving your goals would be to pay into both the NHS pension and a Sipp, rather than choosing one or the other.

We assume you have nominated your ex-wife to receive your death-in-service benefits, as under normal circumstances an ex-spouse would not receive these. In any event, it would be wise to complete a nomination form to confirm the exact position. If the nomination form predates the divorce this will need to be revisited.

If you die, six months' pension at the full amount of your income will be paid out followed by a long-term dependents’ pension. Your existing service would be enhanced by 50 per cent of your prospective future service to the state pension age of 68, which would be a significant amount. Your daughter would then receive 16.875 per cent, or potentially more until she is age 23. As she is only three years old this could make a big difference towards possible private education costs.

The rules on who qualifies for an adult survivor’s pension have been relaxed, so if you die this could be an eligible spouse, civil partner or qualifying partner.

You and your ex-wife are each investing £50 per month into Vanguard LifeStrategy 80% Equity Fund for your daughter. This is a decent fund with low charges. However, as your daughter is only three years old and you are investing modest regular premiums, there is an argument for investing 100 per cent of this money in equities. A Vanguard global index fund could be a good choice.

Also consider whether this money should be held in a Junior Isa. Although there may be practical reasons for holding it in your name, this will only work if you and your ex-wife agree on when and if the money can be accessed, and how it will be spent. If the money is in a Junior Isa control will pass to your daughter when she is 16, and she can access it at 18, so takes away the risk of any disagreements.

 

Rachel Winter, senior investment manager at Killik & Co, says:

You plan to take out a mortgage while accumulating savings in your Isa. This makes sense if the expected return of the Isa portfolio exceeds the cost of the mortgage. But in five years, after the expiry of the fixed term of the mortgage you plan to take out, interest rates are likely to be higher. If you could use your investments to pay off some of the mortgage when its fixed-rate term expires, consider reducing the volatility of the portfolio by allocating a higher proportion of it to non-equity investments such as corporate bonds.

Private secondary school fees could amount to £200,000 in total, so it is worth considering a separate savings plan for these. If your ex-wife is not a higher-rate taxpayer it would be more tax-efficient to hold these savings in her name.

On the basis of the information you have provided, opting out of the NHS pension scheme could be an option as you want to access funds before age 67.

Although not relevant to you at present, it is still worth putting money into a Sipp if you are a basic-rate taxpayer. Investments held within a Sipp do not incur income or capital gains tax, so returns can compound at a greater rate. This could make a significant difference over long time periods. And you can take a 25 per cent tax-free lump sum from a Sipp after the age of 55.

 

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

You have substantial UK exposure on the grounds that this equity market is cheap, but you want overseas assets over the long term to diversify the exposure you’ll have to the UK via your house. But the sort of things that might cause the UK market to rise, such as relief that the world economy is avoiding recession, would also benefit global equities. So think about adding exposure to global equities quite soon.

You ask why people would want to invest in countries with a weak rule of law. The answer is that they are prepared to take big risks. We should regard emerging markets as a play on investor sentiment rather than their growth prospects. If you avoid emerging markets, you’ll miss out on big gains and big losses.

Watch out for duplication of holdings when you buy funds. For example, BP (BP.) and Royal Dutch Shell (RDSB) are among both Law Debenture Corporation's (LWDB) and Edinburgh Investment Trust's (EDIN) top 10 holdings. This is partly because large funds that want to hold large UK-listed dividend payers only have a few stocks to choose from.

There’s something to be said for buying such stocks. But make sure your allocation to them is the result of a conscious decision rather than an accident. This is perhaps another reason for having the core of your portfolio invested in tracker funds, alongside a few other funds.

 

Andrea Sproates says:

You want investment growth of 4-5 per cent a year to produce an income of about £12,000 in today’s money in about 15 to 18 years. Whether or not you opt out of the NHS pension scheme,  you need to consider your Sipp's investment strategy.

You are taking the right approach by looking to create a diversified portfolio of property, equities and bonds. The right mix would give you good growth potential, and also provide some diversification and protection against stock market falls.

You are right not to try to time markets. Very few people, if any, can time markets consistently, and those who try often get it wrong and lose money as a result.

We agree with using core passive funds to provide broad low-cost exposure to markets alongside some active funds, which give the potential for outperformance.

We also think that there is value in the UK stock market. However, it is difficult to assess the effects that currency movements will have on share prices and even harder to predict future currency movements. You believe that UK shares will benefit if sterling strengthens. But while strong sterling would reduce returns from overseas markets, it could also lead to falls in FTSE 100 companies that earn a significant proportion of their revenue from overseas, as this revenue would then be worth less when converted back to sterling.

About 60 per cent of your Sipp is in UK equities, with 25 per cent in cash and 15 per cent in global investments. So if you invest in more UK funds you are in danger of being too heavily exposed to the UK.

Over the longer term you want to have at least 70 per cent of your investments in non-sterling assets. This would help you to diversify away from the UK, which you need to do, but is perhaps too much. It would also introduce extra risks as your returns would be more influenced by currency moves.

A sensible split may be to allocate between 50 per cent and 60 per cent of your investments to the UK, both now and in the longer term. You could hold passive funds such as FTSE 100 and or FTSE All-Share trackers and exchange traded funds (ETFs). Alongside these you could have active exposure to smaller companies, as you already do via Henderson Smaller Companies Investment Trust. And you could benefit from good quality investment teams and managers, for example, via Liontrust Special Situations (GB00BG0J2688) which has an excellent track record as a result of its investment process. The fund's managers aim to identify companies with strong barriers to competition and an ongoing competitive advantage.

Your overseas equity exposure could be focused on the US and Europe and accessed through global tracker funds or ETFs. But you should also include some exposure to Asia and emerging markets, which could be high-growth areas over the coming decades. Funds for getting exposure to them include Invesco Pacific (GB00BJ04K596) and JPM Emerging Markets (GB00B1YX4S73).

As your pension fund grows, you should add more exposure to other asset classes such as fixed interest, and bricks and mortar commercial property funds.

We are concerned about the risks to fixed interest because some assets look expensive. So we prefer to use flexible strategic bond funds with experienced fund managers such as Jupiter Strategic Bond (GB00BN8T5935) and Baillie Gifford Strategic Bond (GB0005947857). We do not think getting exposure to fixed interest via passive funds is a good idea because their largest exposures can be the companies with the most debt. The indices passive bond funds track can also have significant concentrations and be constructed according to fairly arbitrary rules.

UK property funds face some uncertainty with Brexit on the horizon, so we generally limit our clients' portfolios' exposure to these to 10 per cent. Property funds we like include M&G Property Portfolio (GB00B8FYD926), Janus Henderson UK Property (GB00BP46GF57) and BMO UK Property (GB00B830G150). 

 

Rachel Winter says:

UK equities look cheap in comparison to many overseas indices, but this is arguably for good reason. A high exposure to UK equities is risky because the threats of a bad Brexit and/or a Jeremy Corbyn-led Labour government are still very real. You are thinking of investing in overseas equities if sterling strengthens to $1.40 against the US dollar. But sterling generally moves inversely to the FTSE 100, so if the pound strengthens to $1.40 it could be quite damaging to your portfolio.

I agree that sufficient legal and regulatory frameworks in some emerging markets are lacking, but at the same time some of these economies have strong growth prospects that are difficult to ignore. And you already have a reasonable amount of indirect exposure to emerging markets. For example, FTSE 100 mining stocks such as Rio Tinto (RIO) and BHP (BHP) currently depend on China for half their revenues.

Passive funds are attractive on the basis of cost, but I strongly believe that you should include some active funds in the portfolio as they can outperform over long time periods. For example, Capital Gearing Trust (CGT), managed by Peter Spiller, has significantly outperformed for the past two decades. And Scottish Mortgage Investment Trust (SMT), which was launched in 1909, has also outperformed over long periods.