Is there enough time for my pension to hit target?

His wife is training for a new job and earns £12,000 a year. She expects to be in full-time work in about two years and should earn double this.

Their home is worth about £750,000 and they have a rental property worth £170,000. Neither of these have a mortgage on them. They have two children, aged 17 and 15.

“I would like to build up a fund of at least £500,000 over the next seven years,” says Peter. “After this time I would like to draw an income from it of about £20,000 a year to top up my occupational and state pensions.

"Four years ago I started a self-invested personal pension (Sipp), although I have been investing for about 15 years. I recently transferred a poorly performing defined-contribution pension into it, as well as my company and personal contributions for the last tax year. So I now have cash of £120,000 in it, alongside investments worth nearly £100,000. I hope to contribute about £25,000 a year to it for the next six years.

"With a time horizon of only seven years there is a risk that we will have an income shortfall in retirement. But I could, if necessary, work for an extra year or two.

"Given the global and UK outlook I wondered what I should hold in my Sipp for the next seven years and where I should invest the cash?

"I hold funds, and a few direct shareholdings in businesses I understand, and that I think could benefit from global trends or offer value. 

"My business has approximately £130,000 retained cash, which is sufficient to cover two years' dividends and pay. I hope, if possible, to increase this further so I have an emergency fund due to the unpredictability of self-employment. I also want a cash surplus in the business that I can draw down gradually and tax-efficiently to top up any shortfall in my pension income. 

"I have cash savings of about £10,000 and my wife has £30,000 in an employee share scheme, which we could use to help cover our children’s university costs."

Peter and his wife's investment 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

Tim Stubbs, independent investment consultant at Tim Stubbs Investment Strategies, says:

To grow your pension pot to £500,000 within seven years, my rough calculations suggest that if you fully invest your £120,000 Sipp cash today and a further £25,000 tax-free at the beginning of each year, you will need your portfolio to make a net return of just over 5.5 per cent a year to have a value of £500,000 seven years from now. Bear in mind that this could mean gross portfolio returns of roughly 6.5 per cent a year before fees, and possibly more, depending on your costs of investment. These include fund, platform and dealing charges.

Such a level of target returns is not far behind those achieved by stock markets historically. So to achieve such a target you are likely to need to invest around 80 per cent of your Sipp in equities, making it a high-risk portfolio. Only a Sipp portfolio that is higher-risk than the one you have now could, on average, be expected to meet your £500,000 goal and leave little room for error. Any tougher years ahead in markets could derail the target.

It also might not be advisable for you personally to have such a high-risk portfolio. Normally you reduce the risk of your investments when you are relatively close to retirement. Your goal conflicts with this because it requires a higher-risk portfolio – and some good luck and bullet dodging. Such an approach might be fine for someone who has 20 years until they retire. But it is a little unnerving when your long-awaited freedom might be closer. If hearing this makes you nervous, reassess your target.

You do not have to invest the large cash allocation in one go. But investing at a slower rate would act as a drag on your expected returns, although with the benefit of reduced risk, pound cost averaging and the flexibility to invest opportunistically, as you would have cash available to take advantage of any notable market corrections. If you invested the £120,000 in three instalments of £40,000 – one now and one in each of the next two years – you would need your Sipp portfolio to make a return of just under 6 per cent a year rather than around 5.5 per cent a year, because the money has to work harder in less time. So you would need a gross annualised return of over 7 per cent, which is a tougher hurdle still. Again, this would require embracing risk, which may not be advisable.

I would probably consider a lower target. For example, if your target was £450,000 I estimate that you would need net Sipp portfolio returns of between 3.7 and 3.9 per cent a year in the two scenarios I outlined above. This would broadly correspond to a gross return of roughly 5 per cent a year, which you can normally achieve with a more moderate or balanced risk portfolio.

Also consider whether such a modified target would provide a better balance of expected outcomes overall, although this depends on your personal preferences and financial comfort. You need to weigh up whether the additional heightened risk required to grow your current assets and future contributions into £500,000 is worth taking, relative to a more moderate target of around £450,000. Such a lower target might make it for easier for you to sleep at night.

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow, Investors Chronicle's economist, says:

Your target of £500,000 in seven years’ time is not unrealistic. If you shift your cash into equities, invest just over £25,000 a year and get an average total real return of 5 per cent per year you should just about make it. But there are lots of 'ifs' here.

A big part of your portfolio should be in a global equity tracker fund. This is because global shares are probably still cheap – the fact that non-US investors have been net sellers of US stocks over the past year suggests that investor sentiment is depressed, and in the past this has been a great lead indicator of rising share prices in the following 12 months. I also wouldn’t rule out a UK tracker fund. History tells us that the dividend yield is a great predictor of longer-term returns. With the yield now above average, it is pointing to decent returns over the next few years.

Another strong case for tracker funds is that they minimise fees. Just as returns compound over time, so do fees. An extra percentage point per year in management charges could easily cost you £900 over seven years for every £10,000 you invest.

But although today it might make sense to be fully invested in equities, subject to the caveat that shares often do badly over the summer months, this will not remain the case for the next seven years because bull markets don’t usually last so long. So you need an exit strategy and, luckily, we have some lead indicators of bear markets.

One is when the dividend yield falls below average. Another is if or when foreigners become big net buyers of US shares again, something you can track with data from the US Treasury.

A third possibility is to use the 10-month or 200-day moving average rule. As Mebane Faber at Cambria Investment Management has shown, selling when the market falls below this average has in the past protected us from nasty bear markets. If markets remain driven by momentum, this will continue to be the case.

You have considerable exposure to UK smaller companies. These carry some cyclical risk because small-caps often get hard hit in a downturn. Smaller companies should do well in normal times, but are you in a position to take on cyclical risk? Would your business suffer in such an event, during which exposure to cyclical equities would compound your losses? If so, consider having more overseas stocks and perhaps even overseas cash. The tendency for sterling to fall in downturns means that dollars and euros help to protect against recessions.

Picking stocks along the lines of themes can be dangerous. Even if you can identify them, it is not guaranteed that a certain company will benefit from them. Investors have historically neglected two issues with regard to this. One is whether a company has enough monopoly power to channel future revenue growth in a sector into its own profits – it needs to be able to exclude rivals. And it also needs to expand efficiently without steeply rising costs. So pay more attention to both issues.

David Henry, investment manager at Quilter Cheviot Investment Management, says:

Considering where you wish to be in seven years, I would suggest investing all the remaining cash in your Sipp portfolio sooner rather than later. Although we think equity valuations are fair rather than compellingly cheap at the moment, seven years is enough time to ride out any market volatility ahead of the time you expect to start drawing from it. But don't only invest the £120,000 cash in equities, given a high proportion of what you have already invested is in risk assets. 

Consider putting around £40,000 of the cash into government bonds and quality investment-grade debt. Although yields are unexciting, they largely exceed those available on cash and history suggests that bond prices rise during stock market drawdowns. An allocation to fixed income would play a dual role in the coming years, partially defending the value of your Sipp portfolio in difficult times and giving you a source of liquidity to top up your equity exposure when valuations are attractive. 

Listed infrastructure investments also offer a relatively stable income in excess of that available from gilts, which could reduce the overall volatility of the portfolio.

You would be better off investing in a range of quality funds rather than direct shareholdings to mitigate the significant level of stock-specific risk that some of your holdings incur. And given your concerns about Brexit and the outlook for the UK, it would make sense to trim the large holding in Standard Life UK Smaller Companies Trust (SLS).

You have little exposure to US markets. Much has been written about how US stocks are relatively expensive. But it is worth remembering that because of the quality and liquidity of companies listed on US markets, US stocks have historically commanded a premium to other regional equity markets. Major growth themes, particularly in technology, are best played through US markets. 

I would consider switching your holding in Primary Health Properties (PHP) into Assura (AGR). This company offers a lower-risk method of playing an ageing population because its investments are focused on GPs' surgeries and it is trading at a much less substantial premium to net asset value.

Tim Stubbs says:

Your Sipp very much fits the bill of the higher-risk portfolio you are likely to need to hit a target of £500,000 in seven years and it is well-diversified. 

The funds you have chosen have the potential for long-term growth. And you have various geographical exposures and a few marginally more defensive diversifiers. A bit more exposure to emerging markets would also be good.

I also like that your Sipp portfolio is mainly invested in diversified funds because this massively reduces company-specific risks, which you have greater exposure to with direct shareholdings. But your Sipp is still high risk as around 80 per cent of what is invested is in equities.

If you decide to dial down the risk by, say, adopting a £450,000 target over seven years, I would suggest diluting the higher-risk holdings by having relatively defensive investments and asset classes alongside them.