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Can I meet my income goal using ethical criteria?

Our experts consider a range of options for this fossil-fuel avoiding reader
April 2, 2020, Ian Futcher and Christine Ross

Sabrina is age 40, married and earns £48,000 a year. Her home is worth about £330,000 and is mortgage free. She started investing 13 years ago into an employer's defined contribution (DC) scheme.

Reader Portfolio
Sabrina 40
Description

Pensions and Isas invested in funds, cash, residential property

Objectives

Retire between 63 and 65 on £20,000 per year, reduce working hours before then, beat inflation, exclude fossil fuel companies from investments

Portfolio type
Investing for goals

"I would like to retire between the ages of 63 and 65 on a retirement income of at least £20,000 a year,” says Sabrina. “And I don’t think I will want to work full time for the next 25 years, but rather reduce my hours at some point. So I am putting more contributions into my pension now as I will probably not be able to contribute as much when I am in my 50s, if I am working – and possibly – earning less.

"I have just started working for a new employer with a final salary pension scheme and pay in 5 per cent of my salary a month. But this is on a time limited contract and I don’t know how long that will last. I also make additional voluntary contributions worth 5 per cent of my income into a DC pension scheme, which amount to £2,100 a year before the tax benefit. I also made contributions into a defined benefit (DB) pension for five and a half years in a previous job, but I have no idea what this is worth.

"I don’t want the value of my money to be eroded by inflation, although I realised fairly late on that I need to invest rather than just hold cash to avoid this happening. As it is some time until I retire, I think I would be prepared for the value of my investments to fall between 20 per cent and 25 per cent in any given year, although would like to spread my risk.

"I have a savings bond worth £18,000, which matures soon. I will invest some of it in my pension and one of my individual savings accounts (Isas), and put the rest in easy access cash accounts, where I currently hold about six months' of my expenditure.

"Following the suggestion of my independent financial adviser (IFA) I have also recently moved some cash Isas into an investment Isa, which is being run by a wealth manager according to the United Nations (UN) Sustainable Development Goals. I also don't want to invest in companies that extract fossil fuels and last year tried to exclude these from my pension investments, but found this a nightmare – fund factsheets don’t provide enough detail. 

"With this tax year’s Isa allowance, meanwhile, I have set up an investment Isa focused on ethical passive funds to see how their returns compare with those of active ones. It is worth a bit over £1,500 and I contribute £300 a month to it. I have not fully analysed what investments these these passive funds hold. But I am also trying to not to be over picky about ethical criteria because I don’t want to end up only eating beans on toast and having no fun when I am retired."

 

Sabrina's investments
HoldingValue (£)% of the investments
Aviva Pensions Liontrust UK Ethical Fund18,9008.02
Aviva Pensions Stewardship Bond Fund16,8007.13
Aviva Pensions Mixed Investment (0-35% Shares) 8,4003.57
Aviva Pensions Diversified Assets Fund8,4003.57
Aviva Pensions HSBC Islamic Global Equity Index Fund17,5007.43
SL ASI Europe ex UK Ethical Equity Pension Fund23,0009.76
Standard Life Ethical Pension Fund 23,0009.76
Actively managed investment Isa100,00042.46
Isa invested in ethical passive funds       1,5380.65
Cash in savings bond18,0007.64
Total235,538 

 

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:

Thanks to Covid-19, delaying investing hasn’t done much harm. The current levels of UK share prices mean that paying off your mortgage has been a better investment in recent years than UK equities.

The bad news is that if you want an income of £20,000 a year in retirement you must now invest. And as we’ve no idea what interest rates and investment returns will be in 20 years’ time, you should invest with a view that you will need a pension pot of at least £500,000 to get such an income. This probably requires you to invest more than £1,000 a month.

You also need to have most of your money in equities. At current real yields, bonds are likely to lose money after inflation, on average. Although they offer insurance against several types of near-term stock market falls, this insurance is expensive. So I’d suggest increasing your equity exposure. At current valuations, shares are cheap for the braver investors.

You’re also wise to open investment Isas alongside your pensions. Doing this helps to spread regulatory risk because the tax treatment of pensions might become less attractive over the next 20 years. It also helps spread risks to your income. This is because if you need access to money, it’s easier to take it out of an Isa than out of a pension, although also always have instant access cash available so that you don’t have to sell equities when markets are down.

 

Ian Futcher, financial planning consultant at Quilter Financial Advisers, says:

Despite your concerns that you have started to invest late, at age 40 you are still in a strong position to maximise your retirement pot. And achieving your aims is realistic.

In terms of generating a sufficient income for retirement, you are on a good position as you have two defined benefit pensions. These will generate some level of guaranteed income to provide a foundation for achieving your desired £20,000 a year income in retirement. Exactly how much income they will generate depends on how long you pay into your current scheme.

To make up the shortfall, moving cash Isas into an investment Isa is a good start. But don’t forget to use your allowances each year – £20,000 for your Isas and £40,000 for your pensions. Any unused pension allowances can be brought forward three years.

 

Christine Ross, client director & head of private office, North, at Handelsbanken Wealth Management, says:

To preserve the buying power of your capital in the long term you need to invest, and doing this will also help you meet your objective of a retirement income of £20,000 a year. Assuming you maintain your current level of savings, I calculate that you are on track to reach your objective of an annual income of £20,000 a year from age 63, which should be sustainable for at least 37 years – as long as your investments generate an average real return of 3 per cent a year. Building up a fund large enough to do this should be achievable over an investment horizon of 20-plus years. At this stage, it does not appear that you will exceed the pension Lifetime Allowance, which is £1,073,100 for the 2020/21 tax year and increases annually in line with consumer price index (CPI) inflation.

You have set aside some cash that would enable you to meet your normal monthly outgoings for six months, which is the amount I normally recommend. Importantly, this means that you will not have to draw on your investments if you need emergency funds. Another positive factor is that all of your investments are held tax efficiently, either in pensions or Isas, which will maximise your returns. 

 

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

Your desire to avoid fossil fuel companies makes equity investing harder for you than investors who do not have this requirement. But you still have many options and not just active ethical funds. There are some exchange traded funds (ETFs) that exclude or minimise exposure to companies involved with fossil fuels. For example, UBS MSCI World Socially Responsible UCITS ETF (UC44), which has an ongoing charge of 0.25 per cent – lower than those of active ethical funds. This ETF also offers more diversified exposure to equities than active ethical funds.

But by avoiding the oil majors you are giving a lot up. You’re losing a way of protecting your portfolio from a surge in oil prices caused by a restriction in supply. This might seem a low risk at the moment, but over a 20-year investment horizon low risks become high ones. You're also losing big dividend payers that enjoy relatively low volatility. Consider getting exposure to pharmaceuticals, utilities or telecoms companies to plug this gap.

Also consider private equity investment trusts, some of which have exposure to clean energy. Listed companies tend to be larger and older than most firms, so might have lower long-term growth prospects than companies that are not yet quoted on public markets. These types of funds carry liquidity risk because their holdings cannot be sold quickly at a decent price in bad times. However long-term investors should be compensated for this danger – at least in theory.

 

Ian Futcher says:

I am concerned about the mix of funds you hold. This type of blended approach does not allow for overall management of your portfolio, and could result in the funds you hold not matching your attitude to risk and over exposure to certain types of assets.

Consider investing in multi-asset funds that could enable you to better match what you hold to your attitude to risk and invest more in line with your ethics.

A fund of funds is run by manager who invests in a collection of single asset funds, so holding one of these results in greater diversification and eliminates the risk of being over exposed to one asset class.

 

James Norrington, Investor’s Chronicle's specialist writer, says:

You hold numerous blended funds, which makes it more difficult to manage your portfolio in terms of understanding which types of asset you are exposed to and how well they match your attitude to risk. We have been reminded in the current sell-off, of the dangers of being too heavily exposed to just one asset class, or asset classes that are affected by the same downside risks (for example shares and high-yield corporate bonds), so you need visibility on what you own.

The first thing is to conduct an audit. Check the factsheets of all your funds and make a note of some key points. What is the asset blend of each fund i.e. the percentage each fund holds in shares, developed government bonds, investment grade corporate bonds, high-yield corporate bonds, emerging market bonds, property/real estate, commodities and alternative investments. Then check the geographical spread of investments and thirdly, check the currency denomination of the investments. All three layers of key asset allocation information will be in the factsheets and Key Investor Information Documents (KIIDs), and you can work out what your overall exposure across the portfolio is.

Next, look at the top 10 holdings in each fund. Be sure to check what percentage of the portfolio the top 10 holdings accounts for, as if low you need to pay even more attention to the high-level asset allocation audit because most of the ‘iceberg’ of what you own is hidden beneath the surface. There might be considerable overlap between funds, so it’s possible you have much more concentrated investments in certain companies or industries than is suitable for your risk appetite.

Having done all of this, you may decide that it’s best to sell some of your blended funds and manage your own asset allocation by selecting ethical funds that specialise in single asset classes. When choosing which funds to sell and selecting single asset funds to buy, you need to ask the same questions. Firstly, how has the fund performed over one, three, five and 10 years. Now we’ve had a sell-off it is possible to see, by contrasting the last 12 months with the previous three to five years, how a fund has done in good times and bad.

Secondly, you want to check the ongoing charges of funds, as costs can eat into your returns, and finally as ethics are important to you, check how your fund providers rank for environmental, social and governance (ESG) factors, on independent websites such as the ShareAction charity.  

 

Christine Ross says:

Your investments are a mix of equity and multi-asset funds with a growth bias, in line with your long-term investment horizon, a significant proportion of which are ethically focused.The current asset mix should allow you to achieve the annual rate of return you need to meet your retirement income objective.

While acknowledging your strong views regarding fossil fuels, I believe it is worth considering funds that invest in this area, but only hold energy companies that make a more positive environmental impact. Managers adopt a variety of criteria when considering what to include in their funds, and some of them invest selectively in fossil fuel companies, alongside greater investments in renewable energy companies. 

Funds such as our ESG portfolios don't have a blanket ban on fossil fuel companies, but rather invest in 'best in class' ones, as rated by index provider MSCI on ESG scores. And while many active ethical funds do not hold fossil fuel companies, some ethical ETFs that target best in class companies in different areas do. 

Some energy companies, meanwhile, invest in renewable energy and/or carbon capture technology. Although in some cases it is only a small proportion of their business activity, as these companies are large their investment in it is large. And we want to encourage companies that are transitioning quickly and penalise those which are not.