Join our community of smart investors

I need enough to cover potential care costs

A reader wonders if he needs to change his investment approach
May 28, 2020, Rosie Bullard and Colin Low

Peter is age 67 and has been retired for seven years. His state and former workplace defined-benefit pension pay him about £54,000 a year. He also receives over £6,000 a year after expenses in rental income from a buy-to-let property, which is worth about £200,000. His main home is worth about £400,000 and both properties are mortgage-free.

Reader Portfolio
Peter 67
Description

Isa, Sipp and investment account invested in shares and funds, cash, residential property

Objectives

Build up sufficient assets to cover possible care costs, leave assets tax efficiently to family, make an overall positive return, reduce number of direct shareholdings

Portfolio type
Investing for goals

“I need to ensure that I will have enough assets to cover possible care costs in the years to come,” says Peter. “When I die I will leave a minimum of 10 per cent of my assets to charity, to reduce the amount of inheritance tax (IHT) my family will pay on the rest of my estate. 

"I do not draw any income from my investments, as my pension and rental income cover my day-to-day expenses. I always put money into my individual savings account (Isa) at the start of the tax year, and recently sold an unwrapped investment, Invesco Japan (GB00BJ04J309), to raise £20,000 for this purpose. Doing this more than used up my capital gains tax (CGT) allowance of £12,300 for the current tax year. 

"I didn't spend all my income over the years, so since the 1970s I have been able to save and gradually build up my investments. I also reinvest dividends paid by holdings that offer dividend reinvestment plans (Drips) and scrip arrangements (shares instead of cash dividends).

"When I retired I used my 25 per cent tax-free pension entitlement to purchase my buy-to-let property. And I invested the money I had built up in additional voluntary contributions in a professionally managed self-invested personal pension (Sipp). I aim for my other investments to beat the return made by the Sipp and make an overall positive return.

"I have a fairly high-risk portfolio but, as I do not need the money in the near future and have a long-term investment horizon, I am generally relaxed about it. However, I would not like my investments to lose more than about 20 per cent of their value in any one year. 

"I don’t try to time the market and aim to remain fully invested, although do make adjustments. If I sell something I usually reinvest the proceeds soon after so that I am not out of the market for long.

"I tend to invest in companies that interest me and that I think will do well over the medium to long term. But the approach of successful investors such as Nick Train and Terry Smith makes me think that I should adjust and improve my investment approach.

"I had always invested in direct shareholdings, but in recent years have started to invest in funds to get overseas equities exposure. For example, I recently added to Scottish Mortgage Investment Trust (SMT), and I am thinking of investing in Smithson Investment Trust (SSON) and other overseas equity funds. I also plan to gradually reduce the number of direct shareholdings, as I cannot properly monitor them.

"I have held venture capital trusts (VCTs) for many years and, in recent years, have invested around £10,000 a year in them."

 

Peter's portfolio
HoldingValue (£)% of the portfolio
Albion Development VCT (AADV)8,1040.53
Albion Enterprise VCT (AAEV)8,2920.54
Albion Technology & General VCT (AATG)16,6481.08
Albion Venture Capital Trust (AAVC)7,7260.5
Crown Place VCT (CRWN)6,7220.44
Diageo (DGE)17,6611.15
European Opportunities Trust (JEO)19,7451.28
Foresight VCT (FTV)4,9290.32
HSBC American Index (GB00B80QG615)23,9811.56
International Biotechnology Trust (IBT)10,5150.68
Kings Arms Yard VCT (KAY)4,4260.29
Marlborough UK Micro-Cap Growth (GB00B8F8YX59)28,4561.85
Octopus Titan VCT (OTV2)17,7351.15
Scottish Mortgage Investment Trust (SMT)52,9723.44
Standard Life Private Equity Trust (SLPE)16,8751.1
Unicorn AIM VCT (UAV)25,5471.66
Vanguard S&P 500 UCITS ETF (VUSA)25,0271.62
Xtrackers FTSE 100 UCITS ETF (XDUK)10,1130.66
Avingtrans (AVG)8,7320.57
Aviva (AV.)5,8770.38
Avon Rubber (AVON)30,6901.99
Clinigen (CLIN)19,7161.28
CQS New City High Yield Fund (NCYF)14,5800.95
Craneware (CRW)23,3461.52
Gooch & Housego (GHH)19,0891.24
Grainger (GRI)11,1150.72
Henderson Far East Income (HFEL)16,0531.04
Hill & Smith (HILS)11,9570.78
Hollywood Bowl (BOWL)7,4100.48
InterContinental Hotels (IHG)7,2720.47
Intertek (ITRK)15,0590.98
Invinity Energy Systems (IES)1,2130.08
iomart (IOM)9,8430.64
JPMorgan Japan Smaller Companies Trust (JPS)17,5641.14
Legal & General (LGEN)17,8281.16
North American Income Trust (NAIT)15,3321
RELX (REL)13,8620.9
Royal Dutch Shell (RDSB)7,0360.46
RWS (RWS)16,4511.07
Spectris (SXS)26,9641.75
Strix (KETL)9,9960.65
Templeton Emerging Markets Investment Trust (TEM)17,3701.13
FW Thorpe (TFW)13,2920.86
TR Property Investment Trust (TRY)17,0071.1
Treatt (TET)30,3891.97
Tristel (TSTL)31,1632.02
Vitec (VTC)22,1331.44
WH Smith (SMWH)7,6160.49
Professionally managed Sipp461,15329.93
Buy-to-let property200,00012.98
NS&I Premium Bonds50,0003.25
NS&I Index-linked Savings Certificates21,1981.38
Cash37,0002.4
Total1,540,780 

 

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:

An important thing you’re doing is reinvesting dividends. History tells us that, over the longer run, most equity returns come from dividends rather than capital gains. This doesn’t mean that you should invest in higher-yielding stocks, as these carry their own dangers, but it does mean you should reinvest the dividends you receive.

I also like that you hold VCTs. But the justification for these isn't their tax breaks as, in theory, these should be offset by lower pre-tax returns. Rather, some future growth will not come from currently quoted companies but from smaller ones that have not yet been quoted. And VCTs give you exposure to these.

However, manager risk is high, as just one or two successful holdings can make the difference between great returns and losses. So you are right to spread your VCT allocation across a number of funds.

Is your investment portfolio really high-risk? It's fully invested in equities and you have fewer diversifiers than many other investors – you don’t have wage income, and don't want to sell your home and move to a cheaper one. But you do have a very safe asset. At current annuity rates, your pension income of £54,000 a year is equivalent to holding a bond worth almost £2.5m. That’s much more than the value of your equity holdings. And what matters in investing is your assets as a whole, so yours, overall, are less risky than you think.

 

Rosie Bullard, portfolio manager at James Hambro & Partners, says:

You can afford to take risk for now as you do not need to draw from your investments to fund your lifestyle. But your investment strategy may need to change if and when you need to draw from the assets to cover the cost of care. 

In the meantime, consider employing a financial professional to help you plan your investment strategy and work out how to draw from your investments in the most tax-efficient manner. This adviser would then understand the wider scope of your finances, so if you needed to delegate authority over them to someone else in later life you would have someone in place you trust and who knows your full circumstances. 

Also check exactly how much of your estate you need to leave to charity to reduce your heirs' IHT rate. There is further information on this in an article on our website as follows www.jameshambro.com/insight/comment/charities-giving/.

I am curious as to why you invest in so many VCTs. These can have attractive tax benefits, but can also be costly and often higher risk with mixed performance results.

 

Colin Low, managing director of Kingsfleet Wealth, says:

You have a strong and very well diversified portfolio. In particular, the VCT exposure is well constructed as you have generalists such as Octopus Titan VCT (OTV2) and Foresight VCT (FTV) alongside technology focused funds like Albion Technology & General VCT (AATG) and Kings Arms Yard VCT (KAY).

Your Isas are also well diversified with a number of different investments in blue-chip businesses and global exposure through country-specific investment trusts. And a holding in property also typically offers further diversification.

You are using drips and scrip arrangements where you can, and this has helped increase the value of your assets over time. Knowing that your investments could pay you a steady dividend is of great significance, especially if your rental income is impacted in a recession.

 

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

It's good that you plan to cut back your number of holdings. Remember the basic maths of diversification: if you held just one stock its performance, relative to the market, would depend solely on its tracking or the volatility of its relative returns. If you added holdings your portfolio’s returns would depend less on the tracking errors of individual stocks and more on the covariances between them. If these covariances were low, you would end up with a portfolio that resembles a tracker fund because outperformance by one stock would be offset by underperformance of others.

There’s nothing wrong with tracker funds, but a portfolio of too many holdings gets the same result for much more expense and time spent acquiring the holdings.

Let’s put some numbers on this. If the average tracking error of your holdings is 30 percentage points, there’s a two-thirds chance of its annual returns being within 30 percentage points of the index. This is typical for a smaller FTSE 100 stock. And if the average covariance of relative returns is zero, if one holding outperforms, there’s a 50-50 chance of another underperforming. Simple maths tells us that a portfolio of 50 stocks has a tracking error of 4.2 percentage points, a two-thirds chance of annual returns being within 4.2 percentage points of the index’s. So your stockpicking efforts are largely wasted.

Trim your number of holdings and avoid clinging on to losing stocks in the hope that they’ll break even, exposing your portfolio to adverse momentum.

The obvious choice in which to reinvest the proceeds of the sales of investments is a global tracker fund. Your investments are underweight overseas equities, which might appear to be a good thing because UK equities seem relatively cheap. But if we'd said that five or 10 years ago we’d have been wrong.

 

Rosie Bullard says:

One way to reduce your number of holdings would be to remove those for which the outlook has changed materially as a result of the current economic and social situation. These may be companies that have reduced or suspended dividends, but of which the yield was a major component of the likely total return, or companies affected by the impact of reduced travel. 

You have a number of tracker funds, which can reduce your overall costs. But if you believe in active management and that you can identify high-quality direct shareholdings or funds, it may be a good idea to sell the tracker funds. You could reinvest the proceeds in high-quality investments that you already hold.

You prefer to get exposure to overseas listed equities via funds. Although these can be an effective way of accessing growth outside the UK, it is increasingly easy to get research on and trade equities listed overseas. So as you particularly like to invest in direct shareholdings, you could start by investing in some well-known overseas listed large-cap companies.

Also consider improving the balance of your portfolio by diversifying away from equities with gold or absolute return funds that have understandable investment processes. These assets can mitigate downside and provide some modest upside.

 

Colin Low says:

There are two ways in which you could, over time, reduce your number of direct shareholdings. You could simply track an index via a passive fund, which would keep costs low. Or you could replace your direct shareholdings with another basket of UK equities in the form of an active fund such as Liontrust Special Situations (GB00BG0J2688) or Finsbury Growth & Income Trust (FGT).

If you go for an active fund you will pay the research teams from these management companies to deliver on performance and volatility objectives. So just as when you employ a plumber or electrician, you need to quantify the cost of that compared with the risk of taking on the job yourself.

You want your investments to have a broader geographic spread and already hold Japan and North America funds. But I think it would be helpful to have a good quality global equity manager who can make those asset allocation and geographic choices on your behalf, with all the data that they have to hand. You already have Scottish Mortgage Investment Trust, which does that to a degree. But, increasingly, this trust is focused on technology and has a significant allocation to unquoted companies.

So other global equities funds to consider include Rathbone Global Opportunities (GB00BH0P2M97), Baillie Gifford Global Income Growth (GB0005772479) or Sarasin Responsible Global Equity (GB00B8369M57).