Pension freedoms have given us more control over our finances – but how can you ensure a regular income? Kyle Caldwell explains.
The retirement landscape has changed dramatically since the pension freedoms were introduced four years ago (April 2015), handing retirees the ability to take control of their retirement savings.
Retirees have been taking advantage of this, and demand for income drawdown has soared while annuity sales have slumped. Although annuities still have their place despite rates being close to historic lows, the flexibility of the freedoms is for many too attractive to pass up. It means, for instance, that they have instant access to pension savings that should grow over time and can be passed on to loved ones when they die.
Therefore, it has become increasingly commonplace for individuals to use their pension pots to pay themselves an income at retirement, whether they are self-directed investors or are paying for professional help through a financial adviser or wealth manager. For those who arrange their investments carefully, a monthly income can be achieved; there are several ways to go about this.
Doing the maths
First things first: some groundwork needs to be done. Calculate the amount of income you would like to achieve – in other words arrive at an annual figure you would like to pay yourself as a 'salary' at retirement, factoring in both essential and discretionary spending.
In financial adviser circles, working out how far the amount of income an individual would like matches up with reality is achieved through cash-flow modelling. This involves calculating a yearly percentage growth rate from the chosen investments in their portfolio in order to achieve their desired goal.
Michael Martin, a private client manager at Seven Investment Management, notes: "I have a lot of clients who want to retire at 60 on £10,000 a month, who ask me how they achieve that. My answer is that we need to get the structure of their investments correct first and then we can move on to calculating what return they need to achieve on their investments."
For some individuals, the growth rate needed for their goal will be too high to achieve without in all likelihood exhausting their pension ahead of their life expectancy; others will find the investment mix required is too high-octane for their risk appetite. Either way, they may opt to lower their income goals. Some, though, may take the opposite approach and increase investment risk to achieve the amount of income they want.
Other bits of general housekeeping include adding the state pension into the income calculation (if you are at an age where you can claim it), as well as any other assets that can be drawn on in retirement, such as ISAs. Those who do have substantial sums in s should look to use them first and leave the pension untouched as long as possible, because the tax rules on leaving a legacy are now more favourable for pensions.
Pension money passed on by those who die before age 75 is tax-free, while for those who die above that age, the beneficiaries will pay income tax on any pension withdrawals they make. No inheritance tax is payable in either case. In contrast, ISAs form part of a person's taxable estate (though they are free of tax when passed on to the ISA holder’s spouse on death).
Rated Fund monthly payers for a year-round income
|Fund||Mainly invests in||Allocation (%)||Yield (%)|
|AXA Framlington Monthly Income||UK Equities||20||5|
|Threadneedle Monthly Extra Income||UK Equities||20||4|
|Artemis Monthly Distribution||Global equities and bonds||10||4.3|
|MI Miton Cautious Monthly Income||Global equities and bonds||10||4.5|
|Liontrust Monthly Income Bond||Bonds||10||5.3|
|TwentyFour Select Monthly Income||Bonds||10||7.1|
|Artemis High Income||Bonds||10||6|
|F&C Commercial Property||Property||10||4.2|
|Overall portfolio yield:||4.9|
Source: compiled from FE Analytics, as at 7 March 2019
Generate the natural income
There are various ways to arrange investments to pay an income at retirement, with perhaps the most obvious being to focus primarily on income-generating assets. To reduce risk, which is particularly important in retirement, a prudent approach is to draw only the income produced by the pension investments (the 'natural yield') rather than eating into capital growth.
In terms of putting together a DIY monthly income portfolio, the hassle-free route is to focus solely on funds paying a monthly income. The downside is that the choice is narrow, as it is far more common for funds to pay quarterly or bi-annually.
However, out of our Rated Fund selections for 2019 we have assembled a hypothetical portfolio of eight funds that all make monthly distributions, with around 50% held in equities, 40% in bonds and 10% in property (see table above for fund choices). The overall yield is 4.9%, but it is worth bearing in mind that this should not be viewed as a ‘buy and forget’ option, as the overall asset mix is adventurous.
That's the case for the bond funds in particular, as they tend to focus on the riskier areas of the fixed income universe, including high-yield bonds. Moreover, a 40% weighting to UK dividend-paying shares is high, especially at this juncture where Brexit uncertainty continues to cloud the outlook.
This yield can be boosted further by adding in a couple of specialist income funds, which have much higher yields as a result of sacrificing capital growth to buy derivatives. Again, there is not a huge amount of choice, but out of our Rated Funds we can use Schroder Income Maximiser (yielding 7.3%) and Fidelity Global Enhanced Income (5%), in exchange for the two lowest equity-based yielders (Threadneedle Monthly Extra and Artemis Monthly Distribution), to bring the overall hypothetical portfolio yield up to 5.7%.
Out of our 201 actively managed Rated Funds, only 10 pay income monthly, so we were constrained in terms of choice. If we widen the net to include funds or investment trusts that pay dividends every quarter, there is a much bigger pool to fish in. It would then be a case of looking at when the dividends are paid and ensuring enough income is being generated each month.
But rather than being fixated on dividend dates, Kay Ingram, director of Public Policy at LEBC, the retirement adviser, suggests another tactic is to simply divide the expected annual income into monthly payments. She adds: "By focusing on distribution dates there's the risk that you could end up with a portfolio that is biased towards an investment style, country or asset class," she says.
There's another downside to this income-focused approach, points out Hannah Goldsmith, founder of Goldsmith Financial Solutions. She advises against putting all your eggs in the income basket, pointing out that this approach comes at a cost: your capital will likely not grow much. She adds:
"While the income booster funds may offer an extra 2% to 3% in terms of yield, the big thing that’s missing is growth, so it is a riskier approach than some investors may realise."
Investment trust dividend heroes for monthly income
|Investment trust||Yield (%)||Distribution dates*|
|City of London||4.6||February, May, August, November|
|Bankers||2.3||February, May, August, November|
|Alliance Trust||1.7||April, June, September, December|
|Caledonia Investments||1.7||January, August|
|BMO Global Smaller Companies||1.1||January, August|
|F&C Investment Trust||1.6||February, May, August, November|
|Brunner||2.2||April, July, September, December|
|JP Morgan Claverhouse||3.9||March, May, September, November|
|Murray Income||5.1||January, March, June, November|
|Witan||2.9||March, June, September, December|
|Schroder Income Growth||4.4||January, April, July, October|
Source: dividendmax *Data shows expected distribution dates in 2019; bear in mind dividend dates can change in future years.
Go for growth
Given that the average life expectancy for a 65-year-old female retiree is 20.9 years and for males it's 18.6 years, Goldsmith argues income portfolios need to cater for the fact that people are living longer than ever before. "The problem with focusing solely on income is that when dividends are cut, not only does income fall but the capital value will also be negatively impacted. Someone in their early 60s could feasibly have a 30-year investment timespan, so I would advocate focusing on growth-producing assets and then selling units to pay yourself an income."
Rosie Bullard, a portfolio manager at James Hambro & Partners, agrees. She points out that the notion of living off the natural yield produced by the portfolio and leaving the capital untouched may have been fine 15 years ago, but there are several problems with it today. One is that in today's low-yield environment, investors may struggle to live comfortably off the income being generated.
Therefore, building an income strategy totally reliant on dividends and fixed income can result in a portfolio being heavily compromised. She adds: "Many income stocks look expensive at present and so the expected return is diminished. It means that far from preserving capital, the strategy could put your savings at risk."
Instead, a mixture of growth and income assets is more sensible. Bullard says by adopting this approach, investors can build a better-balanced portfolio that can be sustained during 30 years of retirement. "It means that, for now, you can avoid a portfolio heavily biased to bonds, assuming you can tolerate the higher volatility associated with shares, and you can buy great companies from jurisdictions that tend to pay lower dividends but are thriving," she says.
One strategy for a mixture of growth and income is to build a portfolio of 'dividend hero' investment trusts that have long track records for growing their dividends year in, year out. In most cases the dividend yields are fairly low, which is a reflection of the trusts' broad emphasis on growing the capital and raising the payout, rather than offering a high level of income.
In order to achieve a monthly income, the trusts selected will need to pay dividends at different times of the year. The table highlights the 10 investment trusts that have raised dividend for 40 years or more, listing their distribution dates. We have also included Schroder Income Growth (LSE:SCF) (23 years of dividend increases) to ensure a monthly income can be achieved. One possible combination uses Schroder's fund alongside Caledonia Investments (LSE:CLDN), City of London (LSE:CTY), Brunner (LSE:BUT) and Witan (LSE:WTAN). Bear in mind, though, that dividend dates can change; you may well also need to supplement the natural yield with an element of capital.
Consider a guaranteed income pot
The final point to make is that while annuities are inflexible and the level of income on offer remains historically low, they do offer something investments cannot promise – income security. For those who do not have any other assets to draw on – for instance, a final salary pension or investments held in an ISA or elsewhere – annuities are worth considering to secure essential spending and living costs. Ingram endorses this approach:
"Annuities should not be rejected out of hand. Instead, they are a very useful tool in covering basic income requirements, whereas the rest of the money can be invested for discretionary spending."
Build a separate cash pot to mitigate stockmarket storms
While 20 to 30 years is a long time to be invested, the stockmarket is not a free lunch; the value of the investments held in a portfolio can suffer violent swings, and when you're drawing an income from the pot these losses are difficult to recover.
That's particularly so if you're drawing on capital to maintain the required level of income when the market falls, as reducing the number of fund units makes it much harder for the fund to recover subsequently.
If you continue to draw income from the pension pot at that stage, a vicious circle is created, resulting in the value of the investments being weakened further. The phenomena is known as pound cost ravaging – the inverse of pound cost averaging.
To avoid this scenario financial advisers, including Angela Murfitt, a chartered financial planner at Fairstone, recommends having a separate cash pot, which can be utilised during lean periods.
"A cash buyer will ensure retirees can continue to receive the amount of income they want however often they want, while also at the same time protecting the value of their investments, as it removes the need to encash fund units."
Murfitt suggests ideally holding two years' worth of income in cash.
Rosie Bullard of James Hambro agrees, adding that if there is a fixed monthly withdrawal, the portfolio can be planned better to ensure affordability and to accommodate market swings. She says: "We always suggest clients have six months to a year’s worth of spending in ready cash anyway. That means if markets take a particularly savage dip, they can postpone drawing income for a few months and rely on cash for a while to give markets more chance to recover, and then replenish their cash savings as and when markets have bounced back."
Be tax-savvy when paying yourself an income
As well as investing efficiently, it also pays to be as tax-savvy as possible when drawing an income.
For some this may mean taking the 25% tax-free pension lump sum in instalments rather than in one chunk, under the hideously titled arrangement, 'uncrystallised funds pension lump sum'.
Another benefit of going down this route is that if the pension pot grows over time, so will the remaining element of tax-free cash.
"Using all the structures available from the government, you can generate a very large income that's free of tax using ISAs, pensions, your dividend allowance, your capital gains tax allowance, savings income and maybe also venture capital trust income," notes Michael Martin, a private client manager at Seven Investment Management.
"You can invest in whatever you wish – in income-producing things or capital-producing things. The return you need to achieve if you are managing your money tax-efficiently is likely to be lower [because you will be losing less in tax], so that means you can take less risk to produce what you need."
These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.
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