When the yield is not enough

“I plan to retire in about five years, at which point our individual savings accounts (Isas), personal pensions and state pensions will be our sources of income,” says Rob. “We will both qualify for the full state pension, which in aggregate should pay us around £16,000 a year.

"I’ve stopped paying into a pension and have taken out Fixed Protection 2016 [which gives a pensions lifetime allowance of £1.25m]. But my pension savings have exceeded the fixed protection amount. We still pay into my wife’s pension annually to receive the tax benefit. 

"I am also considering closing a personal pension which has an annual charge of 0.45 per cent and consolidating all my pension savings on one platform.

"We currently spend most of our income, but when the children go to university we will no longer have to pay school fees, so will use the money we currently spend on that to boost our savings. However, our children won’t qualify for the full student loan amount so we will need to top up their income.

"We want to preserve the value of our investments, and achieve capital growth over the long term equivalent to consumer price index (CPI) inflation plus 3.5 per cent over five-year rolling periods. When I retire we plan to draw around 4 per cent a year of the capital value. This rate of withdrawal should ensure that our capital lasts for the rest of our lives and gives us an income of at least £60,000 a year. 

"We’ve been investing for about 20 years, but have rarely dabbled in direct shareholdings as we don’t have the time to monitor them. We get some of our exposure to equities via passive funds because they are a good way to keep overall costs down. But we also have some active equity funds to try to achieve outperformance and for exposure to emerging markets and smaller companies. 

"I would say that our attitude to risk is medium to high as we could tolerate a fall of up to 30 per cent in any given year. But we think financial markets are overvalued, so have tried to diversify our portfolio to protect our investments against a major setback. We have exposure to equities, infrastructure and property, and would like to diversify further. We are looking at ways to access private equity and alternative assets.

"However, we have tended to avoid bonds because we are afraid that negative interest rates will lock in losses over the long term. Instead, we have instant-access cash Isas. 

"We also wondered whether it is time to switch some of our funds that invest via a growth investment style to ones with a value investment style?"

Rob and his wife's portfolio

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

THE BIG PICTURE

Chris Dillow, Investors Chronicle's economist, says:

You intend to draw down 4 per cent of the value of your investments per year. At their current value, your investments would give you just under £70,000 a year, but you are currently spending most of your £150,000 salary. So could you definitely get by on £86,000 a year?

I’m not as convinced as you that equities in general are overpriced. The above-average dividend yield on the FTSE All-Share index and substantial foreign investor selling of US equities during the past 12 months suggest the opposite. And although US valuations look stretched, they are justified by the economy’s low inflation and unemployment rates. The problem is not so much valuations but the risk of recession. However, in the US interest rate cuts have reduced the risk of this.

Your portfolio does not resemble that of someone who fears an immediate market fall, with less than 10 per cent in cash. This matters because it is hard to diversify general market risk and emerging markets rarely do this. These tend to be driven by sentiment and tend to be more cyclical than mature markets, so might fall by more than the latter in the event of a serious downturn.

I also don't think that property would provide much protection as this tends to become illiquid in downturns. This isn’t a problem for long-term investors who can ride out cyclical downturns and, in theory, should be compensated for taking cyclical risk. But it is a big problem for anyone who might need to raise cash.

Petronella West, chief executive officer of Investment Quorum, says:

The complexities of retirement today mean that most people need advice at the point of drawing income due to the various tests – benefit crystallisation events. This is particularly relevant in your case as you have breached your pensions lifetime allowance. However, the lifetime allowance tax charges only apply once you have withdrawn in excess of your lifetime allowance, and it is only at a rate of 55 per cent if you withdraw all the excess as one lump sum. 

Also bear in mind that interest on student finance is nearly 6 per cent a year, so is saddling graduates with far higher levels of debt post university.

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

Investments held within Isas and pensions grow tax efficiently, and pensions are also very generous from an inheritance tax (IHT) and estate planning perspective.

To some degree, you have a choice of how much tax you will pay on the surplus over the lifetime allowance in your pension and when you pay it. If you to crystallise it in one go, drawing the full 25 per cent tax-free lump sum, you will exceed your lifetime allowance. But you don’t have to take all the excess as a lump sum and incur a 55 per cent tax charge. And as your estate is well over the IHT threshold, paying 55 per cent and bringing the surplus back into your estate is unlikely to be the best option.

The reason for the 55 per cent tax charge is an assumption that someone who exceeds the lifetime allowance will have a top rate of income tax of 40 per cent when they eventually draw money out. So, for example, if £1,000 of your pension incurred a 25 per cent tax charge it would reduce to £750. And if that subsequently incurred 40 per cent income tax, you would be left with £450 – so the equivalent of 55 per cent tax. 

But as there is no obligation to crystallise the whole pot in one go you could leave the excess within the pension and incur a 25 per cent tax charge when you crystallise it. You are able to stagger the crystallisation of your pension and it is only once 100 per cent of your lifetime allowance has been used that you exceed it and incur tax.

For example, you have a £1.25m lifetime allowance due to your fixed protection so could crystallise £125,000 of the pension. That would use up 10 per cent of your lifetime allowance and leave 90 per cent to be put towards future crystallisations. From that £125,000 you could draw £31,250 – 25 per cent – as a tax-free lump sum and any withdrawals you take from the remaining £93,750 would be subject to income tax. There is lots of flexibility regarding amounts and timings.

You plan to retire well before state pension age so there will be a number of tax years where you will have the full personal allowance as you will have no other income. This is currently £12,500 a year, so you have a window of opportunity to release some taxable income from your pension pot on a tax-free basis. And you can draw £60,000 a year from your pension, Isa and cash savings. Within the pension you will be able to take both tax-free lump sum and taxable income, enabling you to draw from that as efficiently as possible with regard to income tax, IHT and lifetime allowance tax charge.

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

It’s good that you are avoiding direct shareholdings: not everyone has the time, skills or – importantly – mindset to pick them adequately. It’s also good that you recognise the many virtues of passive tracker funds. And I share your scepticism about bonds and preference for cash – bonds might do a better job at insuring against some types of near-term stock market fall, but you pay a high price for this insurance.

You are wise to consider private equity. I suspect that many of the best growth companies are not yet listed on public markets. You can access this asset via private equity investment trusts, but the performance of such funds is variable because the distribution of corporate fortunes – one or two big successes offset many failures. This argues for holding a few of them to spread manager risk.

But some of the funds you hold, such as Lindsell Train Global Equity (IE00B3NS4D25), Fundsmith Equity (GB00B41YBW71) and Rathbone Global Opportunities (GB00B7FQLN12), have a similar strategy. They invest in moat stocks – companies with a degree of monopoly power – and this has paid off well in recent years. But you risk concentrating and duplicating your holdings, for example a number of your funds' 10 largest holdings include Paypal (US:PYPL).

Another danger is that having ignored the merits of moats for years and caused such stocks to be underpriced, investors might now be making the opposite error – overpricing them. But this is not a reason to dump funds that hold them: even if such stocks are overpriced it’s impossible to tell when the correction will come. But I would urge caution: a fund’s good track record might be a sign that its holdings are overpriced – not just that its manager is good.

Petronella West says:

You have chosen your funds wisely, and have active funds run by some very good managers, alongside ETFs. If you are retiring in five years it might be sensible to maintain a well-diversified strategy and avoid single-stock risk. Also, if you are going to spend more time in Asia when you have retired consider how you would monitor direct equity holdings and keep abreast of company news as there is now less free research. 

But we think that investors should still keep 'risk on' during retirement to avoid inflation and longevity risk – factors that are woefully underestimated by retirees who tend to focus on security of investment returns.

There has recently been a move out of growth stocks to value stocks, which have underperformed over the past few years. But its dangerous to follow the herd, and the best global growth companies continue to be remarkably profitable and to deliver cash flows. So investors would be wise to consider using any meaningful market corrections to buy or add to both growth and value plays.

Consider holding a higher weighting of your portfolio in higher yielding funds that can accumulate dividends and achieve some capital growth to help secure your £60,000 a year income target. Going forward, it might become more difficult to secure 4 per cent a year net of fees from just yield – especially with such a high exposure to growth. A total return strategy might be a better option.

The following funds could help you to achieve a total return strategy and to diversify your portfolio: Liontrust Monthly Income Bond (GB00B3Y38F6), Jupiter Asian Income (GB00BZ2YND85) WisdomTree UK Equity Income UCITS ETF (WUKD), Man GLG UK Income (GB00B0117C28), M&G Emerging Markets Bond (GB00B7GNKY53) and LF Miton European Opportunities (GB00BZ2K2M84).

To finance these purchases I would consider selling your direct equity holdings and reducing funds invested in property-related assets, as you have meaningful exposure to residential property in the UK and Asia.