Investors with substantial SIPP or ISA portfolios – worth, say, £250,000 or more – should have little difficulty generating a decent and sustainable income from their pots, but the situation may be quite different for those with smaller portfolios.
On one hand, they are under pressure to take greater risks in order to boost their income; on the other, they are potentially more vulnerable to market corrections that could seriously erode their capital.
“Those with smaller portfolios typically have fewer sources of income and could be particularly worried about the impact of a stockmarket downturn on their portfolios, especially given the strong run we’ve had for equities,” says Andy Coles, a chartered financial planner at Beaufort Financial.
We asked a number of independent financial advisers for their ideas on how to construct sustainable income portfolios for investors with smaller sums to invest, which they regard as anything between £10,000 and £250,000.
Set a realistic target
Before the financial crisis, it was relatively easy to generate a natural income of 5% a year, whether from a cash-based savings account or a diversified investment portfolio.
But with interest rates at historic lows and stockmarket gains pushing the yield on shares lower, this is no longer the case.
“It’s still possible to achieve a higher level of income by focusing on less secure fixed-interest assets such as high-yield bonds and emerging market debt, and utilising equity income funds that take more risk, but this approach can leave investors with a more concentrated, higher-risk portfolio,” says Patrick Connolly, a certified financial planner at Chase de Vere.
“This is the last thing those with smaller pots need. Their pots tend to be less diversified anyway, as there isn’t as much money to spread around.”
Most financial advisers we spoke to regard a natural yield of 4% as a sensible target nowadays, regardless of the size of an investor’s portfolio.
That is because an investment approach should focus first and foremost on long-term asset allocation: in other words on holding a diversified portfolio of assets with the optimal mix dictated by the level of risk you are comfortable taking, not by the size of the investment pot.
More cautious investors could reasonably expect to have a higher natural yield than more adventurous, growth-orientated investors at the outset, given their greater exposure to bonds and defensive stocks that pay decent dividends.
For example, Philip J Milton & Company is currently achieving a natural yield of 4% for cautious investors, 3.7% for balanced investors and 3.4% for adventurous investors.
However, over time adventurous investors have the potential to generate more income, thanks to the superior growth prospects of their portfolios.
“The more cautious the portfolio is, the less chance there is that the income produced will grow over time,” says Ben Yearsley, a director at Shore Financial Planning.
“The biggest mistake people make when retiring is to stick it all in bonds, because they typically still need their income to grow.”
Consider capital withdrawals
If the natural yield is insufficient – as is likely for those with modest investment pots, who tend to be more reliant on a single portfolio for income – it can be topped up by making withdrawals from capital, taking either the capital growth or the initial capital itself.
“However, it’s best to generate some gains first and then take those, rather than anticipating them,” says Philip Milton, chartered financial planner and founder of the eponymous firm.
Using your capital carries risks, of course, especially in a market downturn (when it should be avoided altogether if possible) – something that could weigh more heavily on the minds of investors with smaller sums.
However, provided you have a timeframe of at least 10 years and are taking a sensible level of income overall – typically no more than 5% if you want to preserve and grow your capital over the longer term – this should not pose a problem.
“You need at least a 10-year timescale for the strategy to work, and the portfolio must have 50% or more in equities, because such an approach needs the growth potential,” says Brian Bradley, a chartered financial planner at Clarke & Partners.
One of his clients invested £203,000 in March 2014. The portfolio has a natural yield of just shy of 4% and she has been taking income of 5%. Currently, the portfolio is worth £205,000. “It works, but there was an element of luck in the timing,” says Bradley.
Investors cannot expect luck to always be on their side, but such a strategy can still succeed without good fortune provided you stick with it over the medium to long term. Milton gives two examples of this.
The first is a client who has invested around £15,000 over the years in a “middle-of-the-road strategy spread over a significant range of components, including dull stocks to help protect against extreme volatility”.
The portfolio’s value dropped to a low of £9,853 in 2009 in the stockmarket crash that accompanied the financial crisis, but it had recovered to £16,200 by 2012 and stands at £21,600 today.
Throughout this time, the client has taken a regular income. “This is the natural flow of interest and dividends received, so something like 4% a year, but its value is rising with the value of the account,” says Milton.
Another client invested £25,000 in 2002, in the midst of the stockmarket downturn that accompanied the bursting of the dotcom bubble. But today the investment is worth £36,600 – almost 50% more.
That is despite remaining invested through the most recent bear market and taking all the income generated.
If you do not need to preserve capital – for instance if you are a retiree in income drawdown with no plans to pass on your pension – you can afford to take a larger slice of your capital as income without detriment.
“That’s because your pot is mimicking a pension annuity to some extent; an annuity aims to return all of the capital over the client’s life expectancy, which is determined from mortality tables at the outset,” says Bradley. “The trick is to not surrender too much – to play it safe, no more than 7% a year for someone aged 60.”
Most cashflow management tools calculate sustainable withdrawal rates based on life expectancy of 99 years. “Given this timeframe, most clients are comfortable that they won’t run out of money,” says Alistair Creevy, a director at Glasgow-based Independent Advisers.
The power of platforms
Platforms have made it easier for investors with as little as £50,000 to invest in the same way as those with larger sums, according to Yearsley.
“Platforms have made putting portfolios together much easier these days, so the amount of money you have to invest has far less of an impact,” he says.
“What small portfolios wouldn’t necessarily have is things like VCTs or crowdfunding, which larger investors are more likely to hold in their portfolios.”
Those with less than £50,000 would not be able to achieve the same level of diversification. With greater concentration comes greater risk, but this can be mitigated by holding more diversified underlying funds – global equity funds rather than those that give explicit exposure to particular geographical regions, for example.
Bradley also points to the power of platforms to manage income withdrawals efficiently. “A typical income portfolio will have a 3-4% natural yield. Everything is rolled up and a level of income selected.
Units are then encashed across the board to meet this figure. For those with more modest sums, capital gains tax does not raise its head, because of the annual allowance.
“You will be encashing across a number of funds, but modern platforms take all this in their stride. Likewise, the level of withdrawals can be increased or decreased at the click of a mouse.”
Both income and gains from an ISA are tax-free, but assets outside a tax wrapper may be liable to tax when withdrawn.
However, based on the current capital gains tax annual allowance of £11,300 a year, you could take 5% capital from a £226,000 investment or 4% from a £282,500 pot without triggering a tax liability.
Bradley believes a maximum of 12 funds is sufficient for portfolios of less than £250,000 and a manageable number to facilitate making regular encashments across the board.
Yearsley recommends having around 20 funds, regardless of portfolio value. He uses the same funds irrespective of attitude to risk too, but changes the proportion in each accordingly: a cautious investor has more in bonds and property, whereas an adventurous investor has it all in equities.
The equity allocation also differs, with cautious portfolios more UK-focused and adventurous portfolios having more overseas exposure.
Coles advocates 20-25 funds for portfolios of less than £200,000. In the current environment, he recommends holding a larger-than-usual cash fund – up to 15% for cautious investors – to help prevent longer-term erosion of capital.
“Smaller investors would be well advised to hold more in cash as an alternative income source during a market dip and reinvest the natural income for growth during that time, as it’s crucial to preserve the capital of smaller portfolios so that it can provide future income,” he says.
Milton, meanwhile, believes in an “extreme level of diversity”. The firm’s largest holding only constitutes some 2.3% of assets under management and a typical balanced portfolio has 45 components, even for a client with £10,000.
“We include currencies, commodities (including gold for safety), income hybrids – you name it, we hold it, to reduce risk and asset correlation -and pursue value-based opportunities as we see them,” he says. His five largest holdings are investment trusts: Aberdeen Smaller Companies Income (ASCI), Blue Planet (BLP), BlackRock World Mining (BRWM), Miton Global Opportunities and Value & Income (MIGO).
Investment trusts can hold up to 15% of their dividend income in reserve each year, to be paid out later, thereby smoothing dividend payments and enabling fund managers to focus on real and repeatable income growth.
They can also trade at a discount to underlying net asset value: any narrowing of the discount supercharges returns for investors.
Other advisers prefer a one-stop-shop for income-seekers with smaller portfolios. Creevy uses multi-asset funds. He favours the Janus Henderson and Standard Life Investments MyFolio ranges to achieve a high diversification.
Chelsea Financial Services likes multi-manager funds for small pots of money, and highlights F&C MM Navigator Distribution (which yields 4.4% at present) and Premier Multi Asset Monthly Income (which yields 4.2%).
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