A larger allocation to equities could help you achieve your target income

“Although I hope to continue working part-time for a few more years I would like to have the option of retiring in about two years,” says George. “I would like an inflation-linked income equivalent to my current salary as I plan to live fairly modestly in retirement – although I own and enjoy flying an aeroplane. I will be receiving the full state pension and an occupational index-linked pension of about £2,200 a year, so an income of about £18,000 a year would probably be achievable if I purchased an inflation-linked annuity with all the remaining assets in my self-invested personal pension (Sipp). I have already crystallised 85 per cent of the value of my Sipp, although am not currently taking any income from it.

"But because annuity rates are likely to remain poor I would prefer to stay invested and draw from my investments to achieve my target income in retirement. I would also like to leave some capital and pension to my partner, and some capital to my ex-wife.

"I have been investing for 11 years and, according to a risk profiling assessment, I have an average tolerance to risk. I would feel uncomfortable if the total value of all my investments went down by more than 10 per cent in a year. So I aim to have around 60 per cent of my investments in cash and bonds. I was very concerned about inflation eroding the value of my investments, so bought NS&I Index-linked Savings Certificates and inflation-linked government bond funds a few years ago. I think I am now overweight the latter but I am not attracted by conventional bonds.

"I aim to have most of the remainder of my investments in equities and 8 per cent in precious metals, so have too much in this area at the moment.

"I always used to invest in low-cost tracker funds, but more recently I have tried to include 20 to 30 direct shareholdings as a small part of my portfolio, an investment approach advocated by US hedge fund manager and academic Joel Greenblatt. I select these shares with an online tool, and aim for them to be diversified in terms of their market capitalisation, industry sector and risk rating.

"I aim not to buy and sell more than one of these per month, and primarily take a buy-and-hold approach.

"I recently sold Britvic (BVIC) and BT (BT.A) out of my Sipp and added Forterra (FORT). I am also thinking of adding to RIT Capital Partners (RCP) to get more exposure to unquoted investments.

George's portfolio

NONE OF THE COMMENTARY BELOW SHOULD BE REGARDED AS ADVICE. IT IS GENERAL INFORMATION BASED ON A SNAPSHOT OF THIS INVESTOR'S CIRCUMSTANCES.

THE BIG PICTURE

Chris Dillow, Investors Chronicle's economist, says:

The striking thing about your investments is that over one-third of them are in index-linked bonds. But maybe you shouldn't be so concerned about inflation. Even mild inflation compounds over time, for example 2 per cent inflation each year would mean that prices rise 50 per cent over 20 years and £1 at the start of that period would only be worth 67p at the end of it.

But this should not affect share prices because it should already be discounted. And a rise in the general price level should, in time, also mean a rise in share prices because shares in a company are ultimately a claim on the real output of the economy. Expected inflation should not alter the value of that claim. So if this is the case you can protect yourself from expected inflation by holding shares.

But a rise in unexpected inflation can be bad for shares. This can be because the things that cause unexpected inflation can also be detrimental to output and profits, for example, rising commodity prices or wages. Or it can be because the Bank of England raises real interest rates in an effort to control inflation, which is detrimental to real share prices. It is these risks that justify avoiding equities rather than index-linked assets.

However, recent history suggests that these risks are small. Since the early 1990s, inflation has been remarkably stable in the face of big shocks to output and commodity prices. A key reason for this is that inflation is largely determined by what people expect it to be, so because they’ve expected lowish inflation, we’ve had lowish inflation.

This could change, so holding some index-linked assets might be warranted. But I’m not sure that you need to hold so many.

Perhaps you are in this sense a victim of your age. US economists Ulrike Malmendier and Stefan Nagel have shown that our portfolios are shaped by our formative years – even in later life. And there was high and volatile inflation when you were in your impressionable years – your mid to late teens. So is this overly influencing you now? This is an especial worry because insuring against inflation is expensive in the sense that expected returns on index-linked gilts are negative in real terms, while those on NS&I Index-linked Savings Certificates are in effect zero.

Expected returns on cash and precious metals are also negative. Their prices should, in theory, rise in line with interest rates and only rise a lot if interest rates fall. This means that around half of your investments are in assets that might offer negative real returns.

This is odd because your desire for an income of £18,424 a year is in principle achievable. A larger allocation to equities could help achieve your target income. These aren't so much at risk of inflation, but rather normal equity volatility and the unquantifiable possibility that future average returns on equities will be lower than in the past. But if you could overcome your fear of inflation you would find it much easier to achieve your target income.

Henk Van De Beek, consultant at Mattioli Woods, says:

You have indicated a target shortfall of around £7,500 a year. Maintaining sustainable, index-linked and tax-efficient income is key when targeting income in retirement. The uncrystallised element of your Sipp is valuable in this respect, as it could allow around £9,600 to be withdrawn in total, tax-free, before other taxable income needs to be drawn.

You need to get a fuller review of this, but it appears that you can plug the shortfall using your Sipp and Isas. Assuming you have around £381,455 of capital, the income required initially equates to only 2 per cent a year.

Annuities are an option, but current rates may not cover your shortfall. However, drawing from your Sipp and Isas could meet your income requirement, although the income from these is not guaranteed. They also offer additional death benefit options and, if necessary, for multiple beneficiaries. You could still buy an annuity with your Sipp assets at a later stage. Your Isas are a way to get tax-efficient income and withdrawals of capital. And the more you take as income [rather than capital], the better.

Rachel Winter, associate investment director at Killik & Co, says:

A Sipp is arguably a more appropriate option for you than an annuity, if you want to leave money to your partner and ex-wife. A Sipp can be passed on to nominated beneficiaries whereas an annuity generally cannot. And annuity rates are low at the moment because these are based on government bond yields, which are at record lows.

You should be able to derive an inflation-linked income of £18,424 reasonably comfortably. If you include your weekend home in the valuation of your assets, you will need a yield of less than 2 per cent to supplement your state pension and existing occupational scheme. A yield of this level should be feasible within your stated risk tolerance.

It's great to have a cash buffer, but I’d question whether you need to hold five years’ worth of expenditure in cash. Investing some of this money should help bring you closer to your target income.

HOW TO IMPROVE THE PORTFOLIO

Henk Van De Beek says:

You are concerned about inflation. Inflation-linked bonds provide some protection but right now come at a cost we feel is not worth paying. Instead, we would increase the portfolio’s diversification by adding investments that deliver inflation-linked returns, for example real assets such as commercial property. We would also add investments that offer uncorrelated returns for growth such as gold to benefit from the protection this asset offers right now.

Based on the risk profile you have set out, we would target an overall asset allocation as follows, excluding your NS&I Index-linked Savings Certificates, cash outside your Isa and residential property.

While it is worth having some cash as an emergency fund, an allocation of 60 per cent to cash and bonds is too high given current low interest rates. We would look to reduce this and diversify, particularly in the area of equities. Active funds are a better way to get exposure to equities if you are looking for a balance of growth, income and some downside protection, rather than a concentrated portfolio of direct equities invested along the lines of only one investment style.

The funds we use to construct portfolios are carefully selected – we aim to pick ones that appear to be best of breed within their sectors and encompass many investment styles. There is a risk in sticking doggedly to one investment strategy: for example value investing has been out of favour for a sustained period.

We currently favour thematic equity allocation because this allows us to target sectors that benefit from long-term demand drivers while avoiding stagnating industries that may constitute a large portion of any given index. We continue to advocate active management, particularly in areas such as healthcare, global insurance and technology, where the expertise of a specialist investment team is worth paying for.

Rachel Winter says:

You have a high weighting in gold and precious metals. Although this should offer protection against inflation, recent movements in precious metals prices have been volatile, so I think your current weighting is a little high, given your risk tolerance. And you do not receive income from these investments.

Government bonds are incredibly expensive at the moment, with many of them offering negative yields. And about 25 per cent of global bonds offer negative yields [at time of writing]. Your index-linked bonds will have performed well, but you may now be overweight these assets. You could consider other non-equity investments that offer more yield, such as commercial property funds and infrastructure funds.

When investing directly in equities it’s good to hold at least 20 different stocks. Although your direct shareholdings are diversified in terms of sector and market, they are all listed on the UK stock market. So you could benefit from more geographic diversification. Sterling could weaken further in the event of a no-deal Brexit and some overseas assets would support the value of your portfolio. That said, overseas assets could underperform in sterling terms if some good Brexit-related news causes a rise in sterling, so it’s important to have a balance between sterling and non-sterling assets.