Your approach is not as conservative as you think

Robert has two final-salary pensions, which pay him £10,383 a year, and he receives rental income of £6,800 a year before tax. His wife receives a final-salary pension of £14,684 a year plus rental income of £6,800 a year before tax. Their combined income after tax over the next tax year will be £36,000.

“We need an income after tax of £56,000 a year to be able to maintain a comfortable retirement, pursuing our hobbies and going on holiday,” says Robert. “Our state pensions will start to pay out during the 2020-21 tax year, and will increase our combined income after tax to £51,000 in the 2021-22 tax year.

“We have cash worth £35,000, which should bridge the income shortfall until April 2023, as long as our buy-to-let properties continue to deliver a 5 per cent yield before tax. Wages are low where we live, so it has not been possible to increase rents in the past five years and we expect this situation to continue for the foreseeable future.

“We would like to exit the buy-to-let market due to growing regulation and increasing risk, but our current tenants are good so we will continue to let the properties until they vacate. When this happens we will sell the properties and reinvest the proceeds in the stock market. We do not expect to incur much capital gains tax (CGT) because house prices in our area have barely moved since we purchased our buy-to-let properties in 2003.

"If we sell the buy-to-let properties by April 2021, we will need income from our investments. We could get this without incurring tax by holding our high-yielding UK funds in individual savings accounts (Isas) and just taking part of their dividend payouts. We will reinvest the dividend payouts we don’t spend to avoid cash drag.

"Our aim is to protect our assets from the ravages of inflation and political risk in the UK, while still allowing them to grow. Whatever is left of our assets at the end of our lives will be passed to our children.

"We want to minimise the amount of tax we pay, so I plan to gradually reinvest the 25 per cent tax-free entitlement from my pensions in our Isas to maximise our tax-free income. However, I have used up 95 per cent of my pensions lifetime allowance so I may face a tax bill when I am age 75 if the investments in my self-invested personal pension (Sipp) grow significantly.

“I have sold all the direct shareholdings in my Sipp and our Isas, and now only invest in low-cost passive tracker funds. I have also moved our investments to a low-cost investment platform, which saves us nearly £3,000 a year in annual charges. 

"I have invested the Sipp and Isas entirely in equities because our pension income provides a secure, bond-like income, which we could live on if we did not receive a natural yield from our investments during a severe market downturn. We understand the risk of the equity market and expect that there will be severe downturns in the future, but think that our investments' global diversification will mitigate severe falls in any one market.

"I have a relative bias to the FTSE 250 index because I think that the FTSE 100 has declined in real value since December 1999. It is also dominated by just 10 companies and many FTSE 100 companies barely cover their dividends. But the FTSE 250 has grown since 1999. 

"I hope that having around 20 per cent of our Sipp and Isas invested in the UK is not an excessive home bias. I want home market exposure to provide dividends in sterling to minimise currency risk.

"We realise that the future cannot be predicted from the past but think our conservative approach has a high chance of success."

Robert and his wife's portfolio

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:

It is a good idea to exit the buy-to-let market. But the problem is that you are not alone. This, together with a likely ongoing stagnation in real incomes and affordability problems, suggests that the prospects for the housing market are bleak. And they might get even worse if we get a recession in the next few years. So brace yourself for losses on your rental properties.

From this perspective, you might not have enough foreign currency exposure, which can mitigate house price risk. Because sterling tends to fall at the same time as house prices do, profits on dollars and euros may offset losses on your property. Your exposure to overseas equities gives you foreign currency exposure. And the extent to which UK house prices could fall because of tax changes and high valuations could be offset by profits on equities. But there is a danger that if or when there is a global recession losses, on housing might be compounded by losses on global equities. This risk might justify holding some foreign currency.

I would not be so dismissive of the FTSE 100. It has underperformed so far this century, but the past is not always a good guide to the future. If the UK economy suffers more years of slow growth – and a nasty Brexit would by no means be the only possible cause of this – mid-cap stocks might suffer relative to more globally diversified shares such as those in the FTSE 100. And megacap stocks grew to that size by doing a heck of a lot right and having sources of monopoly power. So don’t write them off entirely.

There’s another way in which the future won’t resemble the past. I like that you’ve thought about how your portfolio would perform in the event of a 1970s-style bear market. All of us should perform such thought experiments – stress tests are not just for banks.

But I’m not sure that the 1970s and 1980s are a relevant precedent. The mid-1970s were grim – there was a real danger that capitalism would not survive. But the early 1980s were fantastic for equity investors because of the diminishing threat of inflation, ending of wage militancy and revival of economic growth. 

And I’m not sure that the next equity bear market will end as happily as the 1970s one did. There’s a non-negligible chance that we’ll see continued weak growth and perhaps increased political threats to profits from nationalisation, regulation and higher taxes. Being globally diversified helps to protect from the risks to UK stocks. But the dangers are not confined to the UK. So this is a justification for having a significant weighting to cash.

But you may be better placed than most to take on these risks. Your wealth is more than sufficient to meet your income needs, and you can create income from capital gains as well as dividends.

You also plan to leave money to your children. So you are, in effect, sharing risk with them: a bear market would eat into their bequest as well as your own wealth. If you are happy with this arrangement, it seems to me that there is very little wrong with your strategy and investments.

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

When you first draw on a pension this is called a benefit crystallisation event and a certain percentage of your pensions lifetime allowance is used. From 6 April 2019 the standard pensions lifetime allowance will be £1,055,000. When you started to draw your two final-salary pensions, you will have received notification from each scheme of what percentage of your pensions lifetime allowance was used up. If this was, say, 20 per cent, it would mean that you have 80 per cent of the pensions lifetime allowance remaining for your Sipp to be tested against, as and when it is crystallised.

As you haven’t yet drawn on your Sipp you have control over when it is tested against the pensions lifetime allowance. It is only when the full pensions lifetime allowance has been used that the surplus suffers an extra tax charge. And with a Sipp there is flexibility over how you crystallise it. You could crystallise the Sipp in full, drawing the whole 25 per cent in one go. Or you could crystallise it in stages and have more than one benefit crystallisation event with the Sipp.

But if you draw the full 25 per cent in one go it would take a number of tax years to reinvest this money into Isas, so there would be a period of time when the money is outside a tax-efficient environment. Also, pension funds are generally free from inheritance tax when you die whereas Isas form part of the taxable estate. So while you should be mindful of your pensions lifetime allowance, consider staggering the crystallisation of your pension so that you draw the 25 per cent tax-free lump sum when needed rather than all in one go.

HOW TO IMPROVE THE PORTFOLIO

Ben Gilmore, investment manager at Charles Stanley, says:

Your key objective is, as a couple, to generate enough income when your buy-to-let properties are sold. Simplicity can work well and, on the basis that the same prescriptive approach does not work for everyone, we would suggest modifications rather than wholesale change. A more diversified and slightly more active approach with an annual rebalance may be effective.

Your investment approach is not conservative due to the large equity exposure. Your global approach may also not mitigate falls in single markets due to the high correlation between equity markets around the world. A higher-risk approach would take a long time to recover if equity markets crash. So we would encourage you to diversify further. 

Asset allocation is the key driver of returns and with an equity-only portfolio the range of returns will be wide. So include some more defensive assets. We suggest having bond funds with a global and US focus. They may not be exciting in their own right, but should provide a buffer in more challenging market conditions.

We would allocate 30 per cent of your investment portfolio to the sterling hedged versions of Vanguard Global Bond Index (IE00B50W2R13), iShares Global Aggregate Bond UCITS ETF (AGBP) and Invesco US Treasury Bond 7-10 Year UCITS ETF (TRXS). We would put an equal amount into each fund and hold them in the Sipp to moderate its capital growth as you are approaching your pensions lifetime allowance.

Within the equity component, we would have a core of passive investments and complement them with a few funds that have the ability to enhance returns. We would reduce exposure to Vanguard FTSE Developed World ex-UK Equity Index (GB00B5B74F71) to 15 per cent of your investment portfolio, and have 10 per cent in each of iShares Core FTSE 100 UCITS ETF (ISF) and Vanguard FTSE 250 UCITS ETF (VMID). 

We would also invest 15 per cent in another global tracker, Legal & General International Index Trust (GB00BG0QP604). This has a similar yield to the Vanguard FTSE Developed World ex-UK Equity Index, but a slightly lower US weighting. It has an ongoing charge of 0.08 per cent.

We would put 5 per cent into each of Fundsmith Equity (GB00B4MR8G82), Lindsell Train Global Equity (IE00BJSPMJ28) and JPMorgan Global Growth & Income (JPGI). And we would put 5 per cent into Fidelity Index Emerging Markets (GB00BP8RYT47) to take advantage of the growth potential and attractive dividend yield of emerging markets. The two global tracker funds are focused on developed markets, so this passive emerging markets fund would provide diversification and should assist returns over time.

With such an allocation, your portfolio would have an overall yield of 2.4 per cent and generate an income of over £34,000, comfortably in excess of your requirements. 

Ben Gilmore's suggested allocation

Source: Charles Stanley, *Morningstar

Jason Witcombe says:

I like your investment strategy. Costs and diversification are two of the key areas that investors can control. I can understand why you view your final-salary pensions as a bond-like asset and feel comfortable putting all of your investment portfolio into equities. A portfolio of three funds might not look very diversified, but Vanguard FTSE Developed World ex-UK Equity Index gives you exposure to more than 2,000 individual companies so is significantly diversified.

You do not have any emerging markets exposure, but if your strategy is to invest on a global basis you should consider some exposure to these regions. There are a number of low-cost, well-diversified emerging market funds available, and it makes sense to include countries such as China, India and Brazil in your investment portfolio. Vanguard Emerging Markets Stock Index (IE00B51KVT96), for example, has an ongoing charge of just 0.27 per cent and holds more than 1,000 individual companies.