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Our reader needs an appropriate asset allocation
March 14, 2019, Freddie Cleworth and Ben Yearsley

Raj is 60 and earns over £100,000 a year. His home is worth £550,000 and has an outstanding mortgage of about £175,000 fixed at an interest rate of 2.2 per cent for the next two years. He is single and does not have any dependents.

Reader Portfolio
Raj 60
Description

Pensions, Isa and trading account invested in funds and shares, cash and residential property

Objectives

Fund early retirement and pay down mortgage

Portfolio type
Managing pension drawdown

“I am trying to work out if I have enough to retire now,” says Raj. “I expect my expenses in retirement to be approximately £2,000 a month excluding mortgage payments, which are currently £1,800 a month. But I could revise my monthly expenditure down to £1,800 per month in a market downturn, if I needed to. I plan to keep at least two years' worth of expenditure in cash so I don't have to sell investments at such a time.

"I have defined-contribution (DC) pensions from various employers, and two small indexed-linked defined-benefit (DB) pensions, which should each pay out about £5,000 a year. One of these has started to pay out and the other will start when I am age 65. I expect to obtain the full state pension when I am 66

"The payout from my DB pension, plus a withdrawal of 3 per cent a year from my self-invested personal pension (Sipp) and individual savings account (Isa), should just about cover my monthly expenditure until age 65 when my other DB pension starts paying out. So I should be well covered by the time I start to receive the state pension a year later.

"But I would like the option of being able to spend a bit more in the early part of my retirement without jeopardising the long-term ability of the portfolio to fund my retirement. And from a peace-of-mind perspective, I would like to pay off my mortgage as soon as possible using cash holdings, or by taking my 25 per cent tax-free entitlement from my pensions. 

"I am in good health, but plan to downsize my home in a few years to fund possible care costs in later years. I want my portfolio to be well structured enough to see me through the next 30 years, so I think it needs a better focus. It has been accumulated over years and I mainly have global funds, with some additional exposure to the US, UK, Europe and emerging markets.

"I have invested directly in some UK-listed equities – Prudential (PRU), HSBC (HSBA) and Standard Chartered (STAN) – to give me China exposure. I have quite enjoyed adding a few direct shareholdings, but I don’t have a strategy for this."

 

Raj's investment portfolio

HoldingValue (£)% of the portfolio
BlackRock World ex UK Equity Index (GB00B39V0V55)523334.56
Fidelity Diversified Growth (GB00B2R8Z055) 348763.04
Fidelity Global Dividend (GB00B7778087)115901.01
Fidelity Special Situations (GB00B88V3X40)245162.14
Fidelity American Special Situations (GB00B89ST706)118651.03
Fidelity Global Focus (GB00B3RDH349)226501.97
Fidelity Global Technology (LU1033663649)233742.04
Fidelity Index UK (GB00BJS8SF95)60830.53
Fidelity Asia (GB00B6Y7NF43)65940.57
HSBC Amanah (GB00BYY2PJ30)97190.85
Fidelity India Focus (LU0457960192)127391.11
Fidelity Global Inflation-linked Bond (LU0393653919)230492.01
Janus Henderson European Smaller Companies (GB0007476426) 177751.55
Invesco Asian (GB00BJ04DS38)192771.68
Fundsmith Equity (GB00B41YBW71)276902.41
iShares £ Index-Linked Gilts UCITS ETF (INXG)140241.22
Marlborough Multi Cap (GB00B90VHJ34)189291.65
Zurich Passive Global Equity (GB00BYTZYP60)12556010.95
Aviva UK Equity (GB00B8DS2001) 42950.37
Aviva Asia Pacific ex Japan Equities (GB0002697828)190501.66
Aviva Retirement Distribution (GB0002352119)35550.31
Standard Life with-profits pension fund169161.47
Standard Life Millennium with-profits fund31350.27
Aegon BlackRock World (ex-UK) Equity Index (GB00B4KSG250)406013.54
Legal & General Ethical Global Equity Index (GB00BYNFZB57)399353.48
Aegon BlackRock Emerging Markets Equity Index (GB00B60ZH053)138181.2
Aegon BlackRock European Equity Index (GB00B66F1K79)318892.78
Aegon BlackRock US Equity Index (GB00B63JXK63)806907.04
Lloyds Banking (LLOY)43610.38
Templeton Emerging Markets Investment Trust (TEM)43620.38
Legal & General (LGEN)51470.45
HSBC (HSBA)58040.51
Prudential (PRU)42110.37
Bango (BGO)20420.18
BP (BP.)36110.31
AstraZeneca (AZN)183671.6
Scottish Mortgage Investment Trust (SMT)115241
GlaxoSmithKline (GSK)103620.9
Fidelity European (GB00BFRT3504)33660.29
Fidelity Global Special Situations (GB00B8HT7153)8980.08
JPMorgan Natural Resources (GB00B88MP089)2430.02
Kames UK Smaller Companies (GB00B142FS18)14970.13
Fidelity Cash (GB00BD1RHT82)8530.07
Capita (CPI)93870.82
SSE (SSE)22510.2
BT (BT.A)23360.2
Standard Chartered (STAN)38120.33
Cash33591329.29
Total1146874 

 

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:

You can afford to retire. If your outgoings really are £2,000 a month then with average luck you could spend this and keep your wealth intact. But does this include, for example, house repairs or new cars over the next 30 years?

And average luck is not assured. It’s possible that long-term average returns will be lower in future than the past, or that we’ll get a big bear market soon. The question is, do you have the means to cope with this possibly small but very nasty risk?

As you have no dependents you have the option of running down your wealth. Or you could downsize your home, although I’d warn you that the outlook for the housing market is probably worse than that for equities, so you should not regard your home as a reliable store of wealth.

If taking these measures is adequate, you have no problem. If not, consider working a little longer. Doing this would yield a high return. If you are earning you can add to your wealth and it means you won't dip into your savings, which you will have to when you are retired. And, for many of us, work enables more options: it’s easier to be in a comfortable job and have the option of retiring than it is to try to find work when retired – if this is necessary.

I would pay off the mortgage with your cash holdings. I assume these earn interest of less than 2.2 per cent, so using cash to pay off the mortgage would in effect be a way of increasing returns on that cash – a penny saved is a penny earned. It’ll still leave you with over £100,000, which is a decent-sized reserve to draw on in a bear market. And you wouldn't have to draw on your pension – it makes sense to leave assets in tax shelters for as long as possible.

 

Freddie Cleworth, chartered wealth manager at EQ Investors, says:

You've accumulated a variety of assets to draw on in retirement. But it might be helpful to plan your retirement in three phases – early, medium-term and later life.

During the early phase you need to decide how to repay your mortgage. Using your cash savings for this would allow your pensions to continue to grow. However, the pensions lifetime allowance is currently £1.03m, although it will increase with consumer price index (CPI) inflation. You have DB pensions, and in addition to these DC pensions worth around £730,000 at present. A few good years of investment growth would mean your pensions exceed the lifetime allowance. If you take the amount over the lifetime allowance as a lump sum you will incur extra tax charges of 55 per cent on this portion, or if you take the amount over the lifetime allowance as income you will incur extra tax of 25 per cent on it. Taxation of significant pension assets is not the worst problem, but reducing the DC pensions by withdrawing up to 25 per cent of them tax-free could mitigate this.

Withdrawing a portion of the 25 per cent tax-free entitlement from the pensions would enable you to repay the mortgage immediately, allow you to spend a bit more during the early years of retirement or cover a few years’ worth of basic expenditure.   

Get your pension arrangements reviewed and discuss the merits of consolidating the DC pensions as this would make taking future benefits simpler. You could also establish an investment strategy that is more in line with your risk requirements. You have a fairly high equity allocation, although this is balanced by a substantial cash allocation and security of future income via your DB and state pensions. But you should not take more equity risk than is necessary to meet your likely income requirements. 

Due to your long time horizon, it is important that you take enough risk to maintain your investments' value in real terms net of fees. Your assets need to finance you through maybe the next 30 years, covering the medium term and later life. Global funds and selected additional exposure makes sense – a diversified asset allocation drives the majority of investment returns rather than fund selection.

 

Ben Yearsley, director at Shore Financial Planning, says: 

You want about £24,000 of net income a year and probably a bit more in the immediate years ahead. So you need gross income of about £30,000 a year. You are already getting £5,000 a year from a pension, and you will receive a further £5,000 in five years’ time, and then the state pension. When you are receiving all of these they will give you over half of your annual income needs. But until then you will need to generate the additional income required.

You have cash outside tax-efficient wrappers of about £300,000. You plan to use £175,000 of this to pay off the mortgage in two years, leaving £125,000, but what interest rate are you earning on the cash and does the mortgage have an early repayment penalty? It could be worth paying down the mortgage now because if you do not your monthly income requirements will be double what you say you need until it is paid off. But you have to balance this against the interest rate you are getting on your cash and whether paying down the mortgage early incurs a penalty.

You want always to hold cash worth at least two years of expenditure, so in reality you have about £75,000 of free cash. I would use this as your spending money over the next five years as you don't have any dependents.

You could put the mortgage money into a two-year bond to maximise the interest you get on it – use a service such as savingschampion.co.uk to seek the best rates. But spread it between different providers: if a bank or building society regulated by the Prudential Regulation Authority fails, the Financial Services Compensation Scheme (FSCS) will cover up to £85,000 per person, per bank or building society.

You would still have a shortfall of about £4,000 a year for the first five years, even if you draw on your free cash. In six years you would need about £15,000 to £20,000, depending on how much the personal allowance is at the time – this tax year it is £11,850. And after that you would need about £10,000 each year.

From April you will have a personal allowance of £12,500, a tax-free dividend allowance of £2,000 and a personal savings allowance of £1,000.

Pension rules are complicated, but generally you should be able to crystallise a portion of your pension each year, 25 per cent of which will be tax-free, with the rest subject to income tax. However, after accounting for your £5,000 DB pension payout, you would have approximately £7,500 of your personal allowance left to offset it against. So you could take about £9,000 to £10,000 out of your pension each tax year and most of it would be tax-free. That, your £5,000 pension payment and £15,000 from your cash savings should be more than enough to cover your needs for the next five years. 

So, based on the information you have provided, you should be able to afford to retire now.

 

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

Your investment portfolio seems to have no strategy. But I’m not sure you need one – all you need is discipline.

Use a general to specific approach, and first determine a broad asset allocation. What proportions of safe and risky assets do you want? Cash is the only truly safe asset, although there is a case for bonds as protection against recession or heightened risk aversion.

When you have decided how much of your investment portfolio to allocate to equities, decide what type you will have exposure to. How much will you allocate to UK equities, how much to developed overseas equities and how much to emerging market equities? And what types of developed market equities – for example, value and/or defensives?

These carry different types of risks to each other. The danger with defensives is that investors might have wised up to their good past performance so caused them to be overpriced. And value stocks might be negatively impacted by recession.

Only when you have determined your asset allocation do you decide on specific stocks and funds. Don't invest in active funds with high fees unless there is a very good reason for holding them, as fees can compound nastily over time.

You already have a number of tracker funds so ensure that this remains the case.

 

Ben Yearsley says: 

If you take out less than 2 per cent a year from your pension for the next five years and nothing from your Isa, as suggested above, you can still aim for reasonable growth. 

Your Isa is mainly invested in direct shareholdings, so you need a bit more diversification – maybe another 10 companies. Financials are one of the cheapest areas of the market, but you already have a substantial allocation to this area.

You could take some profits on AstraZeneca (AZN) as it's had a strong run recently, which is possibly overdone.

But I wouldn’t worry too much about your Isa investment strategy as this is a relatively small part of your wealth. You seem to enjoy investing in direct shareholdings, so carry on with that. Just make sure that your shares don't all have a similar profile to each other.

Your Isa could be a good way to generate a tax-free income. You could easily get £4,000 a year from it, if necessary, by just taking the natural income from dividends. So maybe diversify it a bit more and focus on decent dividend-payers.

You should transfer the assets held outside tax-efficient wrappers into a tax-efficient environment, so you could use them to fund next year’s Isa contribution. Most of the holdings outside pensions and Isas are quite small, so I would be tempted to sell them and just add the cash to the Isa. If you have made gains on these, do not sell more in any one tax year than you can offset against your annual capital gains tax allowance [which is £12,000 for the 2019-20 tax year].

Your Sipp, which is worth around £730,000, is the pot of money that needs to start generating around £10,000 a year in six years' time. Even if you take out £9,000 to £10,000 a year for the next five years, you will only need 2 per cent each year to top up your DB and state pension payouts from age 66. As long as there is no market meltdown, your Sipp should be large enough to live on – especially as you are not looking to pass on any wealth.

But your pensions' asset allocation is a mess. I would sell all the pension investments and transfer the cash to one Sipp provider to make managing it far easier.

Then I would set the long-term asset allocation. I would go for a balanced approach, taking some risk as you still want the pot to grow – you are only 60. I would have 10 per cent in property, 25 per cent in bonds, 40 per cent in UK equities and 25 per cent in overseas equities. Within the equity portion, I would ensure that there is exposure to different investment styles, for example some growth and value equities, and different areas such as infrastructure and smaller companies.

You have a mix of index trackers and active funds, but they do not all do different things to each other or complement each other. For example, you have three global equity trackers and three global equity active funds. A core and satellite approach would be a good idea, but you need to work out what you want as the core and what you want as satellites. So, for example, you could have one global equity tracker fund and one UK equities tracker fund as the core of your portfolio, alongside some smaller allocations to a number of active funds. 

In the Sipp I would stick to collective funds and have not more than 20, so each holding accounts for around 5 per cent of it.

You could get exposure to property via investment trusts as closed-end funds are a good way to hold illiquid assets [see 'Consider the cost of UK commercial property', IC, 8 March 2019]. And access bonds via open-ended funds because there is a far greater number of these focused on this asset than investment trusts. 

 

Correction

On page 3 of our Isa supplement of 1 March we stated that: "Not more than £5,000 per tax year can go into a lifetime Isa – your £4,000 maximum contribution plus a government bonus of up to £1,000. But in the same tax year you can invest a further £15,000 into other types of Isa."

This is incorrect. The government bonus of up to £1,000 doesn't count towards your annual Isa allowance. So if you invested £4,000 into a lifetime Isa in the same tax year you could invest a further £16,000 into other types of Isa.