Both active and passive funds have a place in a portfolio

“We want income of £60,000 a year before tax,” says John. “We aim to get most of this by selling investments held outside tax-efficient wrappers, offsetting any gains against our annual capital gains tax (CGT) allowances. This amount equates to an average long-term investment return of around 3.3 per cent from our equity investments, including dividends and accounting for inflation. 

"We would also like to gift about £300,000 to our children in a few years. We plan to fund this by selling equity holdings, and hope to cover the loss of income from our investments with my state pension. We will cover any further shortfall by drawing on our cash and fixed income investments.

"We also plan to leave our self-invested personal pensions (Sipps) and home to our children. We aim to maximise the value of our Sipps, within the annual and lifetime allowance limits, and will continue to move money into these and our individual savings accounts (Isas) each year. But we appreciate that we will have to do further inheritance tax (IHT) planning.    

"Our risk tolerance is relatively high on the basis that our fixed income and cash holdings should mean that we are not forced to sell equity holdings to plug an income shortfall. We could tolerate a fall in the value of our investments in any given year of over 50 per cent. 

"Most of our equity investments held up relatively well during the market sell-off earlier this year, with the exception of Vanguard FTSE UK Equity Income Index (GB00B5B74684). Despite this, I think we should stick with this fund for the long term.

"We have set aside cash worth £240,000 to invest in two or three bond funds over the long term. We already have about £57,000 in bonds via Vanguard LifeStrategy 80% Equity (GB00B4PQW151), but would like to add to this asset. So we are considering investing in Jupiter Strategic Bond (GB00BN8T5596) and MI TwentyFour Dynamic Bond (GB00B57TXN82)."

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:

You’re making good use of tax shelters and allowances. And you have reasonable expectations for returns: although there is huge uncertainty about equities’ long-term prospects, an assumption of 3.3 per cent a year for real total returns seems reasonable.

You are heavily invested in passive tracker funds, which save money on fees, something important as fund managers’ charges compound horribly. Passive funds are also, in effect, a fund of all equity funds so a bet that average opinion about all stocks will be right. This will not actually be the case because some stocks are overpriced and some are underpriced. But unless you can tell which is which, or invest with fund managers who can, there’s no point deviating from average opinion. Passive tracker funds save us from making stock-picking mistakes and you don’t need to believe that stock markets are efficient to buy them.

Onochie Eneh, investment manager at Redmayne Bentley, says:

You are aiming for an income of £60,000 a year before tax. But many UK companies have suspended dividends in recent months due to uncertainty, and with interest rates likely to remain low for a while it makes sense to get some of your income from capital growth. Doing this also means that you have exposure to several different companies and sectors. And cash preservation is incredibly important for companies at present, so you may not be able to rely on historically reliable dividend payers over the next 12 months.

However, when you sell investments to generate an income [outside of tax-efficient wrappers] consider your CGT position.

Consider investing in a portfolio of Aim shares that benefit from Business Relief to mitigate a potential future IHT liability. You would remain in control of the assets, and benefit from any growth or income they generated. Investing in Business Relief-eligible businesses can mean that these assets are excluded from your estate faster than ones passed on via potentially exempt transfers or gifts. It is worth seeking advice from a tax specialist on your options, especially as tax treatment could change in the future.

Angela Marson, chartered financial planner at Fairstone, says:

You are using your CGT allowances to release capital from your unwrapped investments in a tax-efficient way. You are also funding your Isas each year and adding to pensions. However, pension contributions are limited to £2,880 net /£3,600 gross per year as you have no relevant income. So you cannot add to them in larger volumes unless your income sources change.

Your biggest issue appears to be your heirs' IHT liability. Firstly, it’s good to ensure that you have up-to-date wills in place and Lasting Powers of Attorney, whereby you appoint trusted third parties to help in the event that you lose capacity. This will ensure that decisions can be made and action taken – regardless of your health and capacity – to safeguard your plans against potential challenges. I would recommend that you effect both Health and Welfare, and Property and Affairs Lasting Powers of Attorney, or at the very least the latter one.

Sipps are IHT efficient up until age 75, so consider taking your tax-free cash entitlement from them and implementing strategies to maintain the tax efficiency of this money. If you die before age 75, pension funds are paid out tax free. But if you die after 75, the funds in the Sipps will be inherited by your beneficiaries at their marginal tax rate. So the 25 per cent tax-free cash entitlement is effectively lost if it has not been withdrawn. If you withdraw the tax-free entitlement from your pensions it would bring it back into your estates for IHT purposes. However, you could consider other IHT mitigation strategies such as gifting, discounted gifting trusts, or gift and loan trusts.

Your inheritance taxable estate is worth over £2m. So you cannot apply the additional residential nil-rate band allowance for IHT of £175,000 per person because of the tapering out of this allowance for larger estates. This would be a valuable allowance for you, and asset freezing and reduction strategies may be able to reduce the value of your taxable estate so that it can benefit from the residential nil-rate band allowance.

Asset freezing can involve using discounted gift trusts and loan trusts to give away future growth on monies, while still retaining a right to income. Asset reducing strategies also involve gifting. But with these you need to be sure that you can afford to give away capital and survive for seven years after making the gifts to ensure they fall outside your estate.

Isas are a great tax planning tool while you are alive, but not so good for IHT planning. However, as you have an appetite for risk assets, you could consider Isas that invest in assets that attract Business Relief on death, for example, certain Aim shares. After two years of holding these qualifying investments, they should attract Business Relief for IHT tax purposes and reduce your taxable estate, while still allowing you to access the capital and/or income during your lifetimes.

Alternatively, you could insure all or part of your IHT liability using a joint life second death insurance policy written in trust for your beneficiaries. This cover would be underwritten and the cost would depend on your health. The benefit of this is that you are effectively covering the tax due from your current income and capital. You could use this as part of a strategy in conjunction with gifting, Business Relief, trusts and the pension strategies set out above.

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

Hoping that the returns of your bond investments will beat inflation is optimistic. Real yields on western government bonds are negative and if investors are right you’ll lose money on them in real terms.

The case for holding bonds is as insurance. If there are fears of weak growth or heightened risk aversion, equities may fall while bonds should do well, offsetting equities’ losses. But this insurance incurs a risk: if the global economy roars back, bond prices will fall and your losses will be even greater than expected.

This won’t happen if there is a continuation of the global savings glut that has driven bond prices up since the 1990s, alongside sufficient growth to push up equity prices. But such a scenario is only one possibility with dangers on either side.

So consider as to whether cash is a better option. This won’t make you money if we fall into recession, but it also won’t lose money if the world economy comes back strongly.

Many UK income stocks, such as transport and mining companies, are cyclical and their high yields are compensation for extra risk. If there is a stronger-than-expected recovery they will probably outperform. This will be the upside to the downside of bonds doing badly in such a scenario. So if you hold both, you have some insurance against both nice and nasty economic surprises.

But you are taking an under-appreciated risk. All your corporate assets are in quoted equities so you risk missing out on the best longer-term growth, which could come from companies that are not yet listed. The stock market is disproportionately skewed towards more mature companies.

This risk is especially likely if the desire to build back better after the coronavirus pandemic proves to be more than mere words, and there is a genuine shift towards a greener economy. One way to get exposure to this is private equity investment trusts.

Onochie Eneh says:

As you have a high-risk tolerance, you are likely to be able to generate greater investment returns by adding more active funds. For example, you hold Fundsmith Equity (GB00B41YBW71), which has a large bias to US equities and a concentrated portfolio, and has achieved investment growth of over 18 per cent annualised over the past five years. This is compared with an annualised return of just over 5 per cent for HSBC MSCI World UCITS ETF (HMWO), which has a similar geographic allocation. This highlights the benefits of active management.

Your only holding which includes exposure to fixed income, Vanguard LifeStrategy 80% Equity, has a 12-month yield of about 1.96 per cent, so consider adding a strategic bond fund. Jupiter Strategic Bond Fund, which you are thinking of, is highly rated and its manager can invest in both government and corporate bonds of various maturities in any geography. This means it could make good returns in different stages of the investment cycle and boost your income. Jupiter Strategic Bond had a 12-month yield of 3.36 per cent, as of 25 June.

Vanguard FTSE UK Equity Income Index Fund provides low-cost exposure to UK blue-chip companies. However, the UK will face many difficulties in the coming months, including Brexit negotiations. So it is worth taking a more global approach, and considering more active funds that have a focused remit and composition.

Angela Marson says:

Although you are heavily invested in equities, these appear fairly diversified and offset by a large allocation to cash. Retaining an element of cash is absolutely key when you have such large exposure to equities and rely on them for income. Having cash will enable you to maintain your income in times of market volatility without having to sell equity investments at bargain basement prices.

You do not hold any of your cash allocation in NS&I Premium Bonds. You can put up to £50,000 per person in these and, although you do not earn any interest on them, your bonds are entered into a monthly draw for tax free prizes. And – importantly – this cash is easily accessible and fully guaranteed by the UK government. 

Most of the funds you hold are passive so are cheaper than active funds. Some argue that passive funds the best way to invest, but there is a place for both active and passive funds in an investment portfolio.

Some areas of the global economy are difficult to access via active funds. And in others managers of active funds struggle to add value over what the main regional indices return but charge higher fees. The US is a good example of this. 

However, there are many other areas where this is not the case. Active funds can add some value in specialised areas such as emerging markets and Europe. So consider your options for further diversification.