Be careful investing in higher-yielding shares

"I am considering drawing from my self-invested personal pension (Sipp) later this year,” says Ramesh. “But I am waiting to see if there is any market volatility as a result of trade tensions between China and the US, and Brexit. "Due to my wife’s salary, I estimate that I will need to draw £25,000 a year to cover our expenditure and holidays. My wife has a defined-contribution pension, but this pot is very small – only £11,000.

"I am primarily looking for growth and always want to have a minimum of £500,000 in the Sipp while I am drawing a pension from it. I also intend to keep three years’ worth of pension withdrawls in cash – £75,000 – in case there is a market crash of the magnitude of the one in 2008. So this would leave about £450,000 invested to generate £25,000 a year, which I calculate would require a return of 5.5 per cent a year. But I would prefer a return of 7 per cent to outstrip inflation, and 10 per cent would be even better!

“I also want to help my children buy homes and am looking to contribute between £50,000 and £150,000 towards this. So I wondered how I can draw up to £150,000 of my assets quickly, without incurring a tax penalty, to purchase a home in the second half of this year? But I would also like these assets to grow in the meantime.

“I transferred my various pension pots into one Sipp and I have been investing it in funds since August 2018. As we returned from living in Europe in late 2017, we only started investing quite recently.

"I have a buy-and-hold strategy, but review my holdings regularly. I aim to have a limited number of funds to keep the investment portfolio manageable.

"I have mainly invested the Sipp in global funds because I fear the UK is not going to do well while Brexit plays out – maybe for some time to come. However, UK equities could make good gains in the future, so I also have a number of UK funds. These are a mixture of large and mid-cap funds, and small-cap funds focused on the UK, the US and Japan. They offer exposure to defensive, cyclical and ‘sensitive’ companies.

"I don’t have any bond funds because I don’t know much about them. And as I have a long-term investment strategy I feel that equities will give me better returns – even if there is a market crash.

"I have kept quite a bit in cash because I have not invested all my pension in one go and because markets are very volatile at the moment. I drip-fed cash into funds – especially when the market recently dived. As a result, I have made up some of my losses. But I wondered where to invest some of the cash I am currently holding?

"Our individual savings accounts (Isas) are mainly to generate income, so I have mainly invested them in large, profitable companies that pay high dividends. The dividend yield of the Isa portfolio over the past year has been about 5 per cent. I looked for secure companies and one or two bargains. But although I bought WPP (WPP) after it had dropped 30 per cent, it plunged another 30 per cent. But with the dividend payments this portfolio’s value is back at the level it was a year ago."

Ramesh 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

Chris Dillow, Investors Chronicle's economist, says:

It’s wise to hold a lot of cash as a precaution against a market downturn. Although there’s no especially strong reason to think a market fall is imminent, it is inevitable one will happen at some point.

It’s also reasonable to steer clear of bonds. It’s likely that government bonds will do better than cash in the event of a recession or market crash as investors flee to assets that protect against falling profits or increased risk aversion. But you pay a price for this: negative real returns on average and the possibility of significant losses if economic growth picks up or it looks as though interest rates will rise.

The issue is whether you should hold cash in a Sipp. Cash rates in Sipps are usually very low and there may be a tax penalty for accessing the money. So it’s better to have your cash in more accessible places such as an Isa or outside tax shelters. With interest rates so low, the tax you save by holding cash in Isas or Sipps is small.

Keep tabs on fund fees as these can compound horribly over time. Even a half percentage point of unnecessary fees on a £30,000 investment adds up to more than £2,000 over 10 years. You are wisely avoiding the mistake that many investors make – holding so many funds that you diversify away the benefit of any of them beating the market. But consider whether the fees active funds charge are really worth the chance of outperformance.

Peter Savage, chartered financial planner at Fairstone NI, says:

You have around £525,000 in your Sipp portfolio, of which you plan to keep £75,000 in cash. You wish to keep around £500,000 in the Sipp at all times and require a return of 5.5 per cent a year to fund your lifestyle. This return has to be net of fund and platform fees, so you will need a gross return of closer to 7 per cent. In the short to medium term, this may be difficult due to market volatility and where we are in the investment cycle. I suspect you will experience some capital erosion, so consider looking for yield rather than growth as you have done in your Isa.

But this doesn't mean that your lifestyle can’t be funded. I suggest you think about cash flow planning. This involves assessing the sustainability of your investments with the aim of providing the retirement income you and your wife require. You should look at when you and your wife will receive your state pensions, and how much you will get. Then consider whether the income from these would be able to offset the withdrawals you take from your Sipp, and what lump sum withdrawals you will require and when. Also look at whether you will need more or spend less in the later years of retirement, because if the latter is likely you could make more withdrawals in the early years of retirement. These could be offset against fewer withdrawals later in life.

You are right to be concerned about a market crash and the effects this would have on your portfolio while you are drawing capital from it. This is known as ‘pound cost ravaging’ because you would be encashing more shares and units of your investments than at other times to fund withdrawals of the same size as the portfolio falls in value. This makes it extremely difficult for the portfolio's value to recover because there are fewer shares and units of the investments in it. However it is difficult to predict when a crash will happen.

Your cash holdings are likely to be earning very little interest so won’t be keeping up with inflation. Consider investing the cash in low-risk alternatives that could provide some growth potential. If there is a crash, such holdings shouldn’t be correlated to equities, so you could sell them and reinvest the proceeds in equity investments when markets are down.

You need to draw £150,000 cash in the near future but don't want to incur a tax penalty for doing this. This will mean withdrawing capital from your Isas and cash savings. You could also withdraw 25 per cent of your Sipp holdings as tax-free cash.

Daniel Smith, wealth planner at WH Ireland, says:

Your are organised and have compartmentalised your assets into Sipps, Isas and unwrapped investments. But I suggest reviewing your needs, and taking an overall view of your financial circumstances when reappraising your assumptions. We continually have to manage our financial assets from the day we start work to our eventual demise, so why set yourself rules such as a minimum Sipp value? Definitions of growth and income are not of great relevance – rather we need to focus on total returns to help maintain financial control.   

You and your wife should evaluate your objectives in the context of your total asset base and future state pension expectations. When your state pensions start paying out you may be able to place less stress on your assets and help rebuild value that may have been eroded.

As you are age 61 you should be able to access the Sipp assets, and 25 per cent of their value can usually be withdrawn without incurring tax. You have sufficient cash within and outside the Sipp to give to your children, if necessary.  But I suggest not drawing from the Sipp for as long as possible, as any growth or income within it are exempt from further personal tax. This is also the case with the Isas.

You should be pragmatic regarding your expenditure and gifting plans. When you know exactly what you need, take only as much volatility risk as is required. There are likely to be times when your portfolio ebbs in value. And your expenditure and secure sources of income are likely to vary, so these factors need to be included in your planning.

But this approach may not be suitable for everyone, which is why it is important to seek advice on your individual circumstances.     

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

Rethink your preference for higher-yielding stocks. Most investors don’t need a high yield because you can create your own dividends each year by selling some of your holdings. What matters is total return. When you buy a high-yielder you are, by definition, buying a share that other investors are avoiding. Which poses the question, why are they avoiding it?

In some cases, it’s because the stock might do really badly in a recession and this is the case with Persimmon (PSN). With others, it’s because they carry some specific risks. For example, Centrica (CNA) and National Grid (NG.) might be nationalised or regulated more toughly by a future Labour government. Do you really want to take such risks?

And sometimes investors avoid such stocks because they think the growth prospects are poor. As you’ve discovered with WPP, this belief is sometimes right. But this is only sometimes the case because growth is more random than investors realise. As long as you are not buying stocks with negative momentum, there might be a case for considering this class of high-yielders.

It’s wise to spread your UK equities between large, mid and small-caps. Small-caps tend to be more cyclical, so should do well while there's not a recession but badly when there is one. Large-caps have tended to underperform mid-caps, perhaps because they have been systematically overpriced. Large funds – especially equity income funds – prefer to invest in them. However, they tend to outperform in really bad times, and yield differences suggest they might be less overpriced now than usual. So spreading your bets is sensible.

Your split between global and UK equities also seems reasonable, and not just because of Brexit. There are many other reasons to believe that the UK will only grow slowly over the longer run. So it could be sensible to buy a global tracker fund with spare cash.

Peter Savage says:

Like many UK investors, you are concerned about how the UK's withdrawal from the European Union will affect your portfolio in the short term. You have around one-third of your investments in the UK and some of these could experience volatility. The small and mid-cap funds are likely to experience volatility if there is a hard Brexit. But the large-caps have overseas earnings so are not wholly reliant on the UK market. If the value of sterling falls, such larger companies will benefit when they convert their profits back into sterling. However, a soft Brexit may increase the value of sterling, which would benefit small and mid-caps. That said, I think a lot of the risk relating to Brexit has already been priced into the market.

About two-thirds of your investments are in overseas equities, mainly the US, Europe and Japan. Also consider some exposure to emerging markets.

Daniel Smith says:

Your overall investment assets are worth £817,280, including cash and your wife’s DC pension fund. You need £25,000 per year, which represents about 3.05 per cent of the current value of your assets. If you give £150,000 to your children for a property purchase, the expenditure need pressure increases to approximately 3.75 per cent.    

A balanced asset allocation across your Isas and Sipp could provide a sustainable return of between 3 per cent and 4 per cent with potential growth to help address inflation, which you have taken into consideration when setting your Sipp expectations. 

Your current investments could make returns of more than 10 per cent in some years, but also expose your wealth to significant falls in value, as some of your direct shareholdings have recently experienced. I would suggest diversifying beyond cash and equities, and adding fixed interest, property and equity holdings diversified by geography and economic sector. This would be to try to control volatility within your tolerance, when you have determined what this is. 

Your investments are equity biased, although their geographic diversification is sensible. By adding fixed interest and other assets you should achieve more predictable returns, helping you to manage your investments during times of volatility. Controlling this is the key challenge when attempting to maintain financial security after earned income reduces and is not immediately replaced by secure income.