Use allowances to draw tax-efficient income

“We need £30,000 a year in addition to our former workplace pensions to fund our lifestyle,” says George. “I draw £26,000 a year from my self invested personal pension (Sipp), which is worth around £1.4m and of which £743,696 is deferred. I have a pensions lifetime allowance of £1.8m and at age 75 I will face a charge.

“We both qualify for state pensions at age 66, which together will add another £17,000 a year to our combined pre-tax income. When we both receive these we won't need to draw as much from our investments, and I expect the amount we withdraw will reduce further as we get older and our lifestyle becomes simpler.

"We hope to draw 3.75 per cent from our non-pension investments each year, so are targeting a return of inflation plus 3.75 per cent over the long term. 

"My wife holds most of our investments outside individual savings accounts (Isas) and Sipps – a portion worth £463,893 – because she is in a lower tax bracket.

"I have been investing for 30 years, and think that I have medium to high risk tolerance because of our substantial cash holding, the income from the DB pensions and the yield from our investments. I think that we could tolerate a fall in the value of our investments of up to 25 per cent in any given year.

"Our fund holdings are mainly equity focused, and we also have small exposures to fixed income, index-linked government bonds and commercial property funds to diversify. I no longer invest directly in equities so get exposure to them via exchanged traded funds (ETFs) and investment trusts.

"I am considering how best to invest the proceeds from the sale of our share in a residential property. I think drip-feeding the money into a global equities ETF over six months might be the best option. 

“I have been underweight the US market for some time because I thought it was overvalued, but remained invested in emerging markets even though they are more volatile."

George and his wife's 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:

A £30,000 post-tax income is feasible as it is equivalent to only around 2 per cent of your investments. With average luck, you’ll be able to withdraw this amount in the form of dividends and/or capital gains, while preserving the value of your investments in real terms.

I like that your holdings include tracker funds and lower-cost active funds as these don't have high fees. And you are right to want to invest in a global equities tracker fund as this is, in effect, a low-cost fund of all equity funds so should be everybody’s default option. Drip-feeding your money in gradually, meanwhile, allows you to buy during dips and invest less when prices are high.

But you are taking on liquidity risk. A number of your funds, such as TwentyFour Income Fund (TFIF), invest in illiquid bonds, while others offer exposure to private equity and property. These types of assets are difficult to sell during tough conditions, so at such times these investment trusts' discounts to net asset value (NAV) are likely to widen considerably. You should be compensated for this risk with average long-term returns that are higher than those of more liquid assets. But never be in a position where you are forced to sell these types of funds at short notice to raise money. This is a strong justification for having a cash allocation.

Sarb Chahal, senior wealth planner at Sanlam UK, says:

First think about the tax wrappers in which you hold investments, as the right ones enable you to draw income and ultimately pass on wealth to your family as tax-efficiently. You and your wife each have a number of income tax allowances still available, as follows, which should enable you to draw a tax-efficient income. 

The following investment strategy could be funded with your wife's investment account and the cash deposits. The aim of this is to meet your objectives of income, capital growth and mitigating eventual inheritance tax (IHT) liabilities. It involves putting £463,893 into an investment bond, and £112,683 into a general investment account in your wife’s name and a portfolio of Alternative Investment Market (Aim) stocks.

An investment bond in your wife's name would enable her to draw up to 5 per cent of its value as return of capital each year with no income tax liability. So she could draw up to £23,194.65 from it each year for the next 20 years. After 20 years, any further withdrawal would be subject to income tax, but by then your income requirement might be substantially lower and met by withdrawals from other assets. You could also assign a portion of the investment bond to family members to reduce your assets' IHT liability.

A general investment account in your wife's name offers the potential for capital growth, and could pay an income of which the tax liabilities are offset against her savings and dividend allowances. She could offset any gains each year against her annual capital gains tax (CGT) allowance, which is currently £12,000.

A portfolio of Aim stocks in your wife's name would offer the potential for capital growth, which could be offset against her CGT allowance. It could pay out an income, if necessary, but any dividends received would be subject to income tax. However, this could be offset against your wife's remaining personal allowance for income tax of £10,750, after she has received her pension income of £1,750. After she has held the Aim shares for two years they should fall outside her estate for IHT purposes.

We have not included pensions in this plan because your wife is restricted in terms of how much she can contribute to one and you are restricted by the pensions lifetime allowance. But we suggest that your wife invests £2,880 into a pension each tax year as she will receive £576 tax relief.

Tony Yousefian, portfolio manager at Beckett Investment Management, says:

You say that you have a medium to high risk tolerance, and could tolerate a fall of up to 25 per cent in the value of your investments in any given year. However, the potential for this level of fall in value normally constitutes high risk – especially in a multi-asset portfolio where different asset classes are held. So consider an asset allocation that is robust enough to withstand different economic and market conditions. A typical high-risk investment allocation could be as follows: equities 75 per cent, fixed income 15 per cent and commercial property 10 per cent.

The overall risk of all your portfolio could be increased or decreased according to the nature of the funds you select. 

If you want a low-maintenance investment portfolio, consider getting your equity exposure via only ETFs. But you are better getting exposure to fixed income and commercial property via active funds run by managers with good, consistent long-term track records.

If you want to take a more hands-on approach I would suggest getting your exposure to equities via active funds. 

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

Unless we get a surprise government bonds will make a loss in real terms. The most obvious reason for holding government bonds is that they help to hedge against certain types of equity risk, for example recession or investors losing their appetite for risk. If you are relaxed about near-term fluctuations and hold a lot of cash, it’s not obvious why you want such expensive insurance.

Government bonds also protect against an intensification of secular stagnation – threats to global growth are not just temporary and cyclical. There’s a danger that long-term growth will be even weaker than currently expected, although this is an unquantifiable, possibly small risk.

You have a lot of exposure to emerging markets which typically tend to do especially badly in difficult conditions. Don't hold them because they offer better long-term growth. Long-term economic growth is not correlated with equity returns, partly because investors anticipate and price it into equities in advance. Rather, emerging market equities should do better than other equities in normal times to compensate for the danger of big losses in bad times. 

Some people would argue that you should increase your exposure to the US. But although high valuations are sustainable if economic growth continues and inflation stays low, there’s a danger that they won’t. And when the investment environment turns against US stocks all equities will probably suffer. So you are heavily exposed to the US market – whatever equity exposure you have.

But I don’t think that you need to take much immediate action in terms of your asset allocation. These are only reasons to think about it.

Eleanor Ingilby, portfolio manager at Sanlam UK, says:

If you follow my colleague's suggestions you will have an investment bond, a general investment account and an Aim portfolio. But as you hold the majority of your assets outside Sipps and Isas, you might incur CGT if you sell investments to restructure your assets. 

It is good that you hold infrastructure funds because these can be a source of alternative income and further diversification.

Around 70 per cent of your investments are in equities, with around 30 per cent of these UK-listed. This is quite a large exposure to a concentrated area, so I suggest slowly trimming that back to 15-20 per cent. The proceeds from these disposals could be reinvested in overseas equities to further diversify your portfolio. It will be especially important to do this if you set up an Aim portfolio entirely made up of direct UK shareholdings. And as Aim portfolios are generally higher risk you could increase your allocation to fixed interest to offset this.

To diversify the general investment account and investment bond, you could invest them in multi-asset funds, which invest in a mixture of assets such as equities, bonds, property, alternative investments and commodities. 

But if you would miss choosing your own investments a mixture of single-asset funds would be more appropriate.

Tony Yousefian says:

Split your equity allocation between UK and international markets on a 60/40 basis. And split your fixed-income allocation between corporate and government bonds on a 60/40 basis. This could result in your investments having the following allocation: UK equities 45 per cent, international equities 30 per cent, government bonds 6 per cent, corporate bonds 9 per cent and commercial property 10 per cent.

If you want your UK equity allocation to have a good chance of outperforming the FTSE All-Share index, put 60 per cent of it into funds that invest in large-cap stocks, and 40 per cent into funds that invest in small and mid-cap stocks. This is because roughly 75 per cent of the FTSE All-Share index is large-caps.

This allocation should give you a reasonable chance of meeting your investment objectives over the medium to long term.