Make your portfolio less fragile and more resilient to uncertainty

“My primary objective is to grow my investments to a large enough value to provide a comfortable retirement,” says David. “I think I will need an income of £40,000 a year on top of our state pensions to achieve this. I would like to be in a position to retire at 60, if possible. We have 18 years remaining on our mortgage and I would like to pay this off before I retire.

"My employer pays 10 per cent of my salary into a group personal pension and I contribute 5 per cent. Its value is currently about £17,500, but every 12 to 18 months I transfer some of my workplace pension into a self-invested personal pension (Sipp). I have invested in workplace pensions for 15 years, but in 2017 transferred the pots from previous employers into a Sipp, since when I have been more proactive about choosing investments.

"My wife has a defined-benefit pension with her current employer and this should pay her around £15,000 per year when she retires.

"We would also like to help our children buy homes when they are young adults. So I would like my investments to make a total return of 7 per cent a year, or inflation plus 5 per cent.

"I would say that I have a moderate to high risk appetite and would be prepared to lose up to 30 per cent of the value of my investments in a bad year. They are diversified to manage risk, although I worry that I’m overdiversified and will end up with returns similar to those of a global tracker fund – but for a much higher cost.

"I have a long-term investment horizon, so take a buy-and-hold approach. When I first started my Sipp, I tried to rebalance by trimming funds that had done well and reinvesting the proceeds in ones that hadn’t done so well. However, this incurred high trading costs, so I now only rebalance when I invest new money or dividend income.

"I mainly invest in investment trusts because they seem to have made better returns than open-ended funds over the long term. They are also cheaper to hold on the platform I use.

"Growth stocks have outperformed in recent years, but the future is unknowable, so I try to hold both funds with a growth investment style and ones with a value investment style. I like funds run by managers who have a clear style and stick with it.

"I think I’m overweight UK equities, so have sold Schroder UK Mid Cap Fund (SCP) and will trim some of my other UK-focused trusts. I want to invest more in the US, probably by adding to JPMorgan US Smaller Companies Investment Trust (JUSC) and North American Income Trust (NAIT). I recently bought Baillie Gifford Japan Trust (BGFD), and will add to my other Japan and Asia funds.

"I’m looking to add to my direct equity holdings and recently invested in Intertek (ITRK). I prefer quality companies with strong balance sheets and am thinking of investing in Compass (CPG).

"When I am older, I want to de-risk my investments by increasing my allocation to defensive equities.

"I also pay £200 a month into my employer’s save as you earn (Saye) scheme and £100 into its share incentive plan. These are tax-efficient, but I don’t particularly want to hold shares in my employer or any other banks, so I plan to sell them when the plans mature.

"My wife doesn't save, but we both expect to save more when our children start school in the next two years and we don't have to pay nursery fees."

David's investment portfolio

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

THE BIG PICTURE

Chris Dillow, Investors Chronicle's economist, says:

The good news is that, with average luck, you should achieve your objective of an income of £40,000 a year in today’s money in 20 years’ time. This requires a pot of £1m, which you could build up with an average real return of 4 per cent per year and annual savings of £15,000.

But there are many uncertainties – and not just whether it will still be possible to make average returns of 4 per cent each year in a world of sluggish economic growth. For example, will you be able to or want to keep your job? Industries and personal tolerances can change a lot in 20 years. So you need to work out how to make your portfolio less fragile and, instead, more resilient to such uncertainties.

In this context, you are right to avoid bank shares. Investing in the industry you work in means putting your eggs into the same basket. You’re also right to want more overseas diversification, to the extent that overseas stocks might provide better diversification against bad news for the UK financial sector. But because the US market is already pricing in a lot of good news it may not be the best diversifier, so also consider European equities.

Another potential diversifier is your home. If you can sell it and buy a cheaper one, you have a way of releasing cash if equity returns fall short of expectations.

George Nabbs, consultant at Mattioli Woods, says:

You will need a retirement pot of at least £800,000 to generate an income of £40,000 a year, assuming a 5 per cent annual withdrawal rate, mainly from your Sipp, while also preserving some capital to help your children buy homes. Based on the current size of your Sipp, contribution levels, investment strategy and time horizon, you might be able to do this by the time you are 60.

But due to your income level, you should think about the impact of the tapered annual allowance. Increasing personal pension contributions can be a good way to address this. If you transfer ownership of the rental property to your wife this could also reduce your tax liability if she is a basic-rate taxpayer.

A simple and tax-efficient way to help your children get on to the property ladder is to invest the maximum amount possible into junior individual savings accounts (Isas) each year, which is currently £4,368. The money could be invested in higher-risk investments due to your children's long time horizon and these would also be easy for you to manage.

You will have greater disposable income when your children start school, so will be in a better position to invest in several different tax wrappers and build a well-diversified, tax-efficient portfolio – now and throughout your retirement. Investments held within Isas do not incur tax, so can provide tax-free income in retirement. Therefore funding these throughout the wealth accumulation stage of your lives should be a key part of both your wealth management strategies. Venture capital trusts (VCTs), meanwhile, could provide tax relief now, and tax-free growth and income over the long term. Isas and VCTs' more tax-efficient income streams could be immensely beneficial during retirement in that they will reduce your dependence on the Sipp.

As time goes on it will be important to monitor your inheritance tax (IHT) position due to the values of your primary home and rental property. Delaying withdrawls from the Sipp for as long as possible and drawing income from other capital could help to mitigate IHT.

Ines Uwiteto, private client manager at Seven Investment Management, says:

The first step of retirement planning is to work out how much you actually need, so you can target the income and growth rate you need to achieve this between now and when you retire. But do you have anything in place to protect you against unexpected problems that might occur between now and the time you are age 60? Find out what protection benefits your current employer provides and see if there are any gaps. Your family and mortgages are the main things that need to be covered.

Paying off your mortgage before you retire is a sound strategy. You mentioned that in two years’ time you would be able to save more, so does your mortgage allow you to pay it down faster with greater payments? This is something worth checking.

If you are targeting an income of £40,000 a year, assuming that £15,000 of that will come from your wife’s defined-benefit pension, you should get close to that figure when you factor in your joint state pensions and the income from the buy-to-let property – if you still have it. So covering the shortfall with your investments is not beyond the realms of possibility.

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

Consider what are the best long-term investments. Over a 20-year period you cannot safely buy and hold direct shareholdings. In the long run, even apparently sound companies can hit disaster. For example, 20 years ago the FTSE 100 index included Corus, Marconi, Invensys, Railtrack, Abbey National and Royal Bank of Scotland (RBS). All subsequently did terribly. We have no assurance that today’s apparently sound companies will not meet a similar fate.

A similar thing is true of fund managers. The fate of Neil Woodford shows that good long-run track records can turn very bad very quickly.

If you really want long-term buy-and-hold assets, tracker funds are by far your best option. And even if the market does OK, on average, over the next 20 years – which is by no means assured – one or two bear markets are pretty much certain. We need protection from these.

You have very few defensive assets other than small amounts of gold and cash. Your largest bond holding, CQS New City High Yield Fund (NCYF), invests in higher-yielding bonds, which might do badly because credit risk rises in recessions.

This allocation is reasonable for now because the outlook for the next few months isn’t disastrous and you need to be heavily weighted to equities to try to make anything close to a real annual return of 4 per cent. But be prepared to reduce equity exposure when the outlook is not so good. There are ways – albeit imperfect ones – of telling when this happens.

If investment trusts’ discounts to net asset value narrow relative to their own history it can be a warning that investors have become too optimistic.

And when securities' prices drop below their 200-day or 10-month moving average it has been a harbinger of a long bear market. Selling a security when that happens can protect against nasty losses, albeit at the price of missing out on a few near-term upward blips.

An easy way to implement such a strategy is by holding tracker funds – another reason to increase your allocation to these. You could maybe do it with the money you transfer into your Sipp each year.

George Nabbs says:

The investment strategy within your Sipp has a sensible skew to equities in view of your target return. Having decent exposure to small and mid-cap companies also makes sense.

Your exposure to the UK is high. So I would not only diversify into other developed markets, but also emerging markets such as China and India – if you are willing to accept the slightly higher levels of risk. And their higher risk could be offset by further asset class diversification.

Some thematic areas of investment such as healthcare and infrastructure, where the growth drivers aren't dependent on the fortunes of particular regions, could also be relevant.

Consider more interesting areas of fixed income to provide additional diversification. And commercial property accessed via real estate investment trusts (Reits) could provide attractive returns due to their dividends. These can be reinvested during wealth accumulation phases and taken as income in retirement.

Ines Uwiteto says:

You want to make good total returns via a diversified portfolio, but your investments are heavily skewed to one asset class – equities. I would increase your diversification across asset classes to improve the risk-reward trade-off. Risk is a multi-dimensional concept: although you are prepared to lose up to 30 per cent in a bad year today, the closer you are to retirement the less able you will be to tolerate such a drop. So build an investment portfolio that meets your required risk. Why aim to shoot the lights out when it isn't necessary to achieve your desired retirement? Make a plan that gets you where you need to be, and stick with it.

I agree that you should sell your employer share schemes as soon as they mature.