Focus on total return to reduce risk

“I would like to retire in December when I turn 60,” says Chris. “I have pensions worth £860,000, which will start to pay out from that age. One of these is a defined-benefit scheme worth £226,000, which will provide an annual income of £4,800. My partner has a pension worth £159,000, which she will start to draw in two years' time.

"When I retire I would like my investments to make a total return of 4 per cent a year. At present, my investment accounts are mostly in cash as I sold out of everything in February just as the market was falling due to the Covid-19 outbreak. On 13 March I re-invested £250,000 of this in Fundsmith Equity (GB00B41YBW71), Lindsell Train Global Equity (IE00BJSPMJ28) and HL Select Global Growth Shares (GB00BJFVF381). These funds rose about 25 per cent in the period after the initial drop, but because I was worried about a second wave I sold most of my holdings in these in June so that there was just £10,000 in each fund. I made a profit of roughly £40,000 in that period.

"I think that I now need to invest this cash in a fairly balanced portfolio to provide retirement income for us in the years to come. And I have chosen the funds I have in mind to provide this income from when I retire in December, as set out below. But I am waiting to see what markets decide they want to do.

"I don’t want to take a lot of risk, but appreciate that I need some equity exposure for growth as I will only be 60. It is only in the past three years that have I monitored my pensions and what they are invested in."

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 real yield on genuinely safe assets is negative. This means that a 4 per cent income can only come at the price of extra risk. The question is: what type of risk?

Your proposed portfolio contains lots of higher-yielding bonds. These carry credit risk – the danger of default. Although the danger of actual default is small, these also incur price risk. If there is another economic downturn the prospect of increased credit risk will cause the prices of higher-yielding bonds to fall.

Equities also carry price risk, and in the case of your proposed holdings not just ordinary market risk. This is because they have a heavy focus on larger UK companies. City of London Investment Trust (CTY), Schroder Income Maximiser (GB00BDD2F083), EdenTree Higher Income (GB0009449710) and Lindsell Train Global Equity (IE00BJSPMJ28) have holdings in shares such as GlaxoSmithKline (GSK), Diageo (DGE), and Unilever (ULVR). Buying into these is a bet that the recent trend of investors favouring large monopoly-type stocks will continue.

I think this is a risky bet as your proposed portfolio is a little too biased to larger UK stocks, and underweight smaller and overseas companies.

Alex Spreckley, head of wealth management at Handelsbanken Wealth Management, says:

The Office for National Statistics places average life expectancy for someone approaching age 60 today at 85 years, with a one in 10 chance of surviving to age 97. This means that you are likely to need to draw income from your investments for 30 to 40 years. Following many years of investing into your pension, planning and preparation, it is now essential to create a broader financial plan to help you draw your income sustainably, via the right products and in a tax-efficient manner.

As you enter retirement you are right to consider how best to draw an income from your assets. I would advise firstly defining the income you require after tax, rather than assigning a desired rate of return to the assets themselves – a subtle but important difference. 

If your costs of living are shared with your partner, a joint discussion of ongoing expenses will help you calculate the minimum target income required for a comfortable retirement. Understanding the ownership of assets between you is also important in terms of your respective marginal rates of income tax, and personal and savings allowances. Ensure that your assets are held in the most tax-efficient manner, and make good use of Isa allowances.

Both you and your partner could consider buying annuities with your defined-contribution pensions to generate a fixed income for a guaranteed period. Obtaining state pension forecasts would also offer visibility on an additional source of future income. [You can check your state pension at www.gov.uk/check-state-pension]. Alongside your other occupational pension income, such stability could compliment the risks taken with your investment portfolio.

With interest rates likely to be extremely low for the foreseeable future, money held on deposit cannot offer compelling returns, but your decision to hold £30,000 in cash as an emergency fund is sensible.

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

You can easily diversify across equities by holding a tracker fund. Why incur active funds' higher charges unless there are one or two you are especially enthusiastic about?

You do not need to invest for income to get income. You can create an income by selling some of your assets each year. What matters are total returns – capital gains plus dividends. If these are greater than 4 per cent a year after inflation, you can draw an income of 4 per cent a year while keeping your capital intact. And if you don’t want to leave a bequest, you could run down your wealth slightly.

With real returns on cash and safe bonds negative, if you want a return of 4 per cent your investments will need to include many risky assets such as equities and higher-yielding bonds. But you can include some safer assets such as government bonds, foreign currency or gold. The latter two are especially useful because there’s a tendency for sterling to fall when investors become more risk averse, meaning that in bad times profits on foreign currency can offset losses on equities. And sterling tends to fall at the same time as UK house prices, so holding foreign currency can help to mitigate property price risk – a particularly relevant consideration for buy-to-let property investors.

You can also mitigate risk by applying a 10-month or 200-day moving average rule. This involves selling risky assets when their prices fall below their 10-month average. Such a rule would not have protected you from this year’s pandemic shock or got you into the market at the bottom. But it would have protected you from previous bear markets such as the tech crash of 2000-03 and the financial crisis of 2007-09.

And such a rule is far easier to implement with a global tracker fund than a complicated portfolio.

Alex Spreckley says:

Although you did well in making a gain of £40,000 during the recent market turbulence, prudent financial planning should always look at investing over years rather than months. I am concerned that you might be tempted to make dramatic changes to your investments in the next market cycle too, but with less success, drastically altering your financial outlook.

Your proposed portfolio appears heavily skewed to equities, with high exposure to cyclical businesses whose fortunes are linked to those of the wider economy. Alongside a position in high-yielding assets, this could be a highly volatile portfolio. If you are a balanced investor, I would expect more diversity with inclusion of assets such as fixed-interest securities, commodities, commercial property and investments that target realistic income yields.

You are targeting an income of 4 to 5 per cent. Although this is not unachievable, seeking such yields over the long run means exposing your portfolio to greater risk levels than you may be prepared for. Low coupons on fixed-income investments and slashed dividends among large companies exacerbate the challenges of achieving this.

So I suggest repositioning your portfolio for at least a 20-year investment horizon and reduce short-term trades. Focusing on a combination of growth and income, and resetting your income expectations to around 3 per cent are likely to be more achievable and – importantly – more sustainable over the longer term. Drawing a sustainable yield of around 3 per cent from your investment portfolio before tax could generate an annual income of around £9,800. Together with your buy-to-let properties and two pensions, this probably equates to a gross income from all sources of around £48,600, and a net income of around £40,000 a year.