Three simple pointers will guide you through the pensions maze, says David C Stevenson.
A fortnight ago, I wrote about building a portfolio designed to provide you with a retirement income – a DIY annuity, if you like. The aim is to take advantage of the pension reforms announced at this year’s Budget. At the core of this approach are three simple points.
The first is that retired investors need a regular, predictable flow of cash to pay the bills. This has traditionally been provided by using your pension pot to buy an annuity (an income for life). In simple terms, the money from an annuity is invested in government bonds.
The income from these, plus the depletion of your capital, is used to give you an annual income until you die. There’s nothing complicated about annuities, but they’re hugely unpopular. That’s partly due to low government bond yields, increased life expectancy and high management and structuring costs, all of which have left annuities providing a low income in return for your pot.
In the new, post-annuities world, you could build your own stream of payments by investing in government bonds and then drawing down on your capital over time. But you need to be aware of two key things.
Firstly, you have to generate a good enough return on your investment so that it can last as long as your retirement. Ideally, you’d want some capital left over to pass on when you die, but the real priority is to have enough to pay the bills while you shuffle around this mortal coil.
The second key point is that you don’t want to destroy your capital (which, after all, provides your income) by investing in risky assets. But in the real world, you can’t possibly hope to make an above-average income without taking some risks – so you need to use your judgement.
Thirdly, just to complicate matters, you also want your capital to grow at least in line with inflation. That introduces another challenge, because the assets most likely to boast some inflation protection (equities) are also likely to be the most volatile.
The good news is that by focusing on certain basics – notably cutting costs – and thinking creatively, you can maximise your retirement income without taking too much extra risk.
So how can we build our own retirement portfolio? First, we need to consider what is a sensible level of return – either as income or as a capital gain – to expect. Last time, I featured a spreadsheet showing what would happen to £100,000 at different rates of return (download it here).
Say you’re 65 and you want an income of £6,000 a year. A return of about 3.5% (a little above current long-term government bond yields) on your £100,000 pot would get you to age 86 before you ran out of cash. As that rate of return rises, the longevity of your pot does too – a return of 5% gets you to just over 88, 7% to just under 90 and 9% to over 93.
Government data suggest that average male longevity post-65 is between 16 and 20 years. So I think most of us would be happy knowing we’d get to 88. This in turn suggests an optimal investment return of 5%-7% to get us to 88 (or over).
It’s possible to get this sort of return. But you have to remember that once you get above a return of around 4% a year, you are going to be taking extra risk. I reckon that every 1% above a potential return of 5% probably involves notching up your potential loss from volatility. There’s no fixed way to measure this, but assets that produce a likely return in the 3%-5% a year band tend not to lose much more than 10%-15%, even in a bad year.
By contrast, those that produce 5%-7% on average over a 15-25 year period tend to see losses of as much as 25%-35% in the bad years. And expected returns of 7%-9% or more leave you open to bad years where losses can be around 40%-50%.
These numbers need to be put in perspective. If you are only investing for three to five years, they are completely unacceptable. But if you face a 20-to-25 year retirement, you should be able to withstand that volatility. Many 65-year-olds need to think about introducing some riskier assets – such as equities – into their pension portfolios.
Build a pot to suit your risk appetite
In any case, in making your decision the most important factor to consider is the risk/return trade off. I’ve simplified this by breaking it down into three investment tiers, with suggested investment options:
• Low risk: for the loss-averse investor who’s happy to eke out their wealth to 85 and beyond, and wants 3%-5% a year, mostly made up of income, I’d focus on diversified bond income.
You could buy your own mix of government securities (ten- and 20-year dated) as well as retail bonds (you’ll have to keep rolling over these five- and six-year structures), or you could use a bond fund from the likes of M&G, Schroders, Newton or Invesco Perpetual.
I would go for a global bonds fund to give you true diversification, but I suspect most would prefer a combination of a UK gilts fund and a UK corporate bonds fund.
A top government bond fund will probably get you a blended return of about 3% and a corporate bond fund about 4%. But be aware that this is not inflation-linked. And your average total return will probably be dominated by the income payout, with very little chance of capital growth to help out if inflation starts rising in the future.
• Medium risk: if you are willing to take some risk (maybe suffering a 15% loss in a bad year) to get a 5%-7% annual return (with about half in the form of income), I’d suggest a twin-track route. Invest in gilts, giving about 3% a year at most, for security.
On top, invest in UK equities that pay decent dividends (giving you 3%-4.5% in income plus potential for capital gains). If you’re looking for a fund, there are similar options to explore as before (Invesco Perpetual, M&G, Schroders, Newton), although I’d also look at specialist outfits such as Unicorn UK Income.
If you’re more confident, consider a three-way split: a third of your fund in UK gilts, a third in UK-focused cautiously managed investment trusts (Personal Assets Trust, Capital Gearing Trust, BH Macro and the Lindsell Train fund would top my list), plus a third in infrastructure and real-estate investment trusts (I’ll be writing about the best ones next time).
This last category should easily be able to produce an income of about 4% a year plus the possibility of a capital gain, but you will see some volatility in prices.
• Higher risk: if you think you’ll live for a long time and are willing to take more risk, or want some capital left to pass on, you may be looking for returns in the 7%-9% range. I’d suggest another three-way split.
Put one third in equity income with a bias towards a globally diversified range of higher-yielding equity funds, such as the Schroders Income Maximiser range (yielding 7%). Put another third in infrastructure-backed assets and asset-backed closed-end funds that invest in a range of assets (I’ll cover these in more detail next time).
Lastly, buy a globally diversified basket of funds that invest in high-yielding, sub-investment-grade bonds, plus a smidgeon of emerging markets bonds, designed to produce an average yield of between 5% and 7% a year. As I said, this is all higher risk – but if you’re looking for higher returns, that’s what you need to take.