Income from £250K, IHT and pensions, and are ETFs riskier than funds?

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Our latest episode answers questions sent in by listeners. Kyle is joined by Craig Rickman, interactive investor’s personal finance editor, to cover a wide range of topics including a realistic retirement income from a £250,000 pension pot, and how to approach fund risk scores. Do you have a question you’d like Kyle or Craig to tackle in a future episode? We would love to hear from you, and the way to get in touch with the team is by emailing: OTM@ii.co.uk

The question timings:

• 00:35: How much income could I realistically generate from a £250,000 invested pension pot at retirement?
• 08:52: What are the pros and cons of leaving my investments in the accumulation fund share class at retirement?
• 13:39: Wide-ranging question related to inheritance tax planning ahead of rule changes next April
• 20:57: Fund risk scores, and are exchange-traded funds (ETFs) riskier than funds?

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Kyle Caldwell, funds and investment education editor at interactive investor: Hello, and welcome to our latest On The Money podcast, a weekly show that aims to help you make the most out of your savings and investments. 

In this episode, we’re going to be tackling questions that have been submitted by listeners, and joining me to provide his expert insights is Craig Rickman, personal finance editor at interactive investor. Craig, thanks for coming on.

Craig Rickman, personal finance editor at interactive investor: Thanks for having me back, Kyle.

Kyle Caldwell: So, Craig, we’re going to start off with a pension-related question, which is very much in your wheelhouse.

Veronica emailed, and said: ‘I’m close to retirement and have a self-invested personal pension (SIPP) that’s valued at around £250,000. My intention is to go into drawdown, making my own investment decisions as I’m comfortable doing so, and I have other savings that I can dip into if needed. How much income could I realistically generate to help supplement my retirement?’

Craig Rickman: I think that’s a good point. It’s a huge question. It’s a situation that everyone will be confronted with at some point. Anyone with a defined contribution pension, when they reach retirement, it’s how do I turn this into an income, not just an income that’s going to support me now, but that’s going to support me in the future as well.

It’s interesting that Veronica said she wants to keep the money invested and draw income flexibly. She’s happy to do that. It’s important to point out that that’s one of the options you have, to turn your pension pot into a retirement income. The other, as she notes, is an annuity. We may come back to that in a second, but we’ll just park that for now and focus on the question that Veronica’s asking.

When it comes to drawing retirement income, this is very much a personal thing, and it depends on several factors. It depends on how much income you need, it depends on any other assets that you may have, any other forms of guaranteed income, whether or not you’re due to receive the state pension anytime soon, or whether you’re retiring before.

There are lots of different things that can influence how much income you need to draw from your pensions. But there are some guides available, some rules of thumb, and it’s certainly worth going through one of those.

The main one is called the 4% rule, otherwise known as the safe withdrawal rate and the Bengen rule. It’s called the Bengen rule because it was developed by an American financial planner called Bill Bengen back in the 1990s.

Bengen calculated that if you withdraw 4% of your portfolio every year, uprated annually to take account of inflation, then your retirement part should last at least 30 years. 

Recently, Bengen updated it to 4.7% to take account of a wider range of factors and updated conditions. So, he thinks that you can withdraw 4.7% a year. So, that might be a useful guide in this instance. So, if you’ve got a pot of £250,000, drawing 4.7% every year. So, if you thought, well, if it was 5%, that’s going to be £12,500 a year. So, that might be a useful starting point.

But it’s important to note that that is purely a guide to income, and there are other things that people need to think about. But, yeah, it might provide a good point to start with.

Kyle Caldwell: Veronica didn’t say how old she is, but as you mentioned, at some point, there will be the state pension as well. 

However, if you’re retiring, say, five or 10 years ahead of being able to claim the state pension, you may need the income generating from your investments to work harder for you to meet the amount that you are aiming to generate and help supplement your retirement.

For me, it’s as simple as getting out a pen and paper and working out how much you need for essential spending. In terms of discretionary spending, think about what you want to do in your retirement. Do you want to go on certain holidays, have certain experiences? Then work out what you need from your investments and other assets to achieve what you want to achieve.

Craig Rickman: Absolutely that. There are other questions to answer with what to do with your retirement pot as well. How to withdraw the tax-free cash element, whether to take that in one hit or whether to draw a bit every year as part of an income tax strategy in retirement. So, that’s the big decision that people face, how to use that pot. 

But how much you draw would depend on other things. If you’ve got sufficient guaranteed income from elsewhere, so if you’ve got the state pension as you noted, but it’s important to flag that not everyone gets the full state pension. People coming up to retirement will need 35 years of qualifying national insurance contributions to get the full amount. But it’s important to factor that in. So, if you’ve got sufficient guaranteed income from other sources, then the withdrawal rates or the amount of income that you can take from your drawdown pot might be higher.

If you’re more reliant on it, so if that’s going to provide the bulk of your retirement income, perhaps alongside the state pension, then you might want to be a bit cautious.

But the important thing is to try and give yourself as much time to plan as possible. So, you wouldn’t want to be retiring or looking at your income options in June and retiring in July. In an ideal world, you want to give yourself more time to plan ahead, so that when the time comes, you know exactly how much income you need to be drawing for it to be sustainable throughout your retirement.

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Kyle Caldwell: And that’s just one half of it - coming up with how much you, ideally, want to generate from your investments. The other half is which investments to choose, what to pick, and how to arrange your investments to deliver on that goal. 

Craig Rickman: Absolutely. We mentioned annuities earlier, which Veronica has said that she doesn’t want to entertain, but that’s the big decision as well. Do you choose a guaranteed income, like you get with annuity, that can give you certainty and security but are rigid?

So, with lifetime annuities, the terms are chosen at the outset and there are various ways that you can secure an annuity income, so you can have it rising in line with inflation, you can have the money or the income passed to a spouse or a dependent should you die. 

Do you want to look at that option, or do you want to keep the money invested, where you have more flexibility but there’s more risk as well because the risk is that you could drain the money too soon if your withdrawals are too aggressive and the investments don’t perform as well as you would hope.

So, that’s another big decision, whether to use one or the other, whether to use a bit of both, and that illustrates why it’s so important to give yourself some time to weigh up the options to try and find the right solutions for your retirement.

Kyle Caldwell: Just to reiterate what you just said there, Craig, you can do both. It’s not an either/or decision. They are often pitted against each other; should you go into drawdown versus annuities. But it’s quite a common tactic for some people to secure their everyday spending through an annuity and then leave the rest of the pension invested, and some of that can go more towards potentially using it for discretionary spending.

Craig Rickman: Yeah. That can work very well for some people because you have that security. You have that security to not be relying, like we were saying earlier, on your drawdown pot. Absolutely, but you do have a bit of security there. That said, some people are more than happy to keep the lot invested and manage the pot themselves. Others will be, no, I purely want a guaranteed income. I want that security with all of it, or they might keep a very small amount in drawdown.

That’s the good thing about it, that there’s no fixed way of doing it. You can have lots and lots of guaranteed income and a bit of drawdown. You could have lots of drawdown and a bit of guaranteed income or half and half. You get to decide.

Kyle Caldwell: So, the next person who got in touch mentioned that they are also close to retirement. Richard said: ‘I’m conscious that I’m heavily invested in the accumulation share class versions of the funds I own. What are the pros and cons of leaving my investments in the accumulation versions over the income versions?’ 

I’ll go first with this one. So, with an accumulation fund share class, if the fund’s underlying investments pay dividends, then those dividends are reinvested.

If you are building your wealth over time and you’re saving towards retirement, for example, then essentially more money is going back into the funds, and that allows for a greater benefit in terms of compound returns in which investment returns themselves generate future gains. 

If you pick the income share class, then all the income generated from the fund in a given year is returned to you, and it’ll go into the cash elements of your accounts.

So, if you’re investing towards retirement and you don’t need the income, I think in most cases you’re better off with the accumulation version of the fund share class because there’s more money working harder for you. 

However, in retirement, you have to think carefully about which one to pick, and I think it’s largely down to personal preference. If you pick the income share class, then the income is coming automatically to you, and you could potentially build an income-producing portfolio that’s paying at certain yields or aiming for certain yields, and you could potentially try and just take the so-called natural income from the portfolio and try to leave the capital value untouched. This can be very beneficial if we have a volatile period for stock markets because you are giving the capital greater opportunity to grow and recover over time.

Whereas if you’re opting for the accumulation fund share class version, it’s more of a manual choice, and there is more work to it, as you’ll need to decide which funds you’re looking to sell down, which fund units you’re looking to reduce. So, you’re going to have to make an active choice about which funds to sell in order to generate the amount of income that you want to take from the investments.

But, as I said, there’s no right or wrong answer. Ultimately, in retirement, it’s personal preference. Any further thoughts, Craig?

Craig Rickman: Not really. I think you’ve covered that off perfectly. It’s a decision that’s a lot easier when you’re building wealth for retirement because you want any income to be added back into the pot and compound over time.

Once you reach retirement, it can become a bit more nuanced. It’s not just a matter of switching on or moving to distribution share classes and having the income paid out. But, as you say, it can be a really useful way of generating the natural yield. For a lot of people, that’s what they want to do with their retirement pot, protect the capital and just draw the income. If only it were that simple.

It’s similar to what we were talking about with annuities and taking an income from a SIPP, it’s a personal thing. You’ve just got to find the right thing for you.

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Kyle Caldwell: It’s also really important to get the balance right in terms of the type of investments that you own.

For example, if you’re retiring at 60, hopefully, you’ve got 20 to 30 years’ investment horizon. So, you want to have a mixture of both growth-producing and income-producing investments.

I think there’s a danger of tilting too heavily towards income-producing investments because that can come at the cost of not sufficiently growing your portfolio over time.

Craig Rickman: Absolutely, and your pension pot continuing to grow in retirement is a really important thing because it could span decades. So, yeah. Completely agree.

Kyle Caldwell: So, the next question is related to inheritance tax and it came in following an episode in which we covered the upcoming changes to inheritance tax from the start of the next tax year in April 2027. For the first time, pensions will be caught by inheritance tax.

I’ll read the question out in full. I’ve withheld the name as they’ve given some personal details here. However, there’s aspects of this question which other listeners will relate to.

The question says, ‘I think it’d be helpful to discuss how inheritance tax can be mitigated from April 2027 for those where the family home is a considerable part of the estate. For example, our joint estate is worth around £2.8 million, including a house worth £1 million. The rest is mostly in SIPPs and ISAs.’

They also mention that they’ve got money in cash building societies.

‘I can make use of gifting rules, but the estate could be liable for around £800,000 in inheritance tax. Trusts may be an option, but I don’t understand the complexity of the different types, and my research so far seems to suggest it may not be worth it.’

Now, Craig, you can’t give specific personalised advice, but what are the key pointers that you can get across for this answer?

Craig Rickman: Sure. I mean this could be another standalone podcast purely because of the complexities within the inheritance tax system, which I’m sure many people have found.

It’s probably best to break this down into two bits. So, how you can give away a home when you die, and how you could potentially give away your family home while you’re alive.

Let’s look at death first. When it comes to passing on your estate, there are some tax-free allowances that you can use, and it’s only the amount or the value of the assets above these allowances that are chargeable to inheritance tax, which is 40%. 

So, one is called the nil rate band, that’s £325,000, everyone gets that. But you can get an extra £175,000 if you own your own home and you pass it to direct descendants.

So, children, grandchildren, stepchildren, that kind of thing. What that means if you’re a married couple, is that you could potentially give away a £1 million. So, people may have heard this, that you can give away £1 million of your estate tax free. That’s why. 

But there is an important part of what’s called the residence nil rate band, the £175,000 you can get for passing on a home, which is that for every £2 your estate exceeds £1 million, £1 of that allowance is withdrawn.

What that means is for a single person, once your estate’s worth £2.35 million, or for a married couple, once it’s worth £2.7 million, your residence nil rate band is lost. So, essentially this means that as a married couple, you can only pass on £650,000. This is particularly relevant for this question for this individual because they say they’ve got pensions, and as you said before, they’re due to fall into the inheritance tax net from April.

This is one of those really strange situations, unique situations, where you could create one of these incredibly painful tax rates of perhaps 80% or more on any unspent pensions.

The reason for that is some people may have heard about this potential double taxation, and if you die after the age of 75 where whoever inherits the pension could pay inheritance tax and income tax, which could create tax rates of somewhere between 52% and 67%.

But if your pension is causing you to lose the residence nil rate band as well, it could create 80% or more tax rates. So, this is one of those situations where that could apply. So, that’s looking at your home on death. 

So, what can you do with your home if you’re alive? Can you give it away to your children? Yes, you can. Because it’s your main residence, private residence, there’s no capital gains tax to pay, so that doesn’t apply. It’s a bit more complicated than that as I’ll explain. So, if you do give your home to your children, you would have to move out of the home.

So, you’d have to give it outright. You could potentially continue living there, but you would have to pay them a market rent. And the reason for that is if you weren’t to do that, then it’s what’s called a ‘gift with reservation of benefit’, which essentially means you’ve given an asset away, but you’ve continued to enjoy it. So, HMRC would say, well, you haven’t given it away because you’re still continuing to use it. So, they’re the things to watch out for.

The other thing is that if you give away your home, then the seven-year rule kicks in, so you have to survive seven years for it to move outside your estate. 

Another aspect is that you no longer own the home, your children own it. So, if they decided at any point, there might be perfect harmony within your relationship, but if they decided at any point that they wanted to turf you out, then they potentially could. 

Inheritance tax is so complicated and so personal that before you were to do anything around it, it’s really important to take professional advice from a financial adviser, solicitor, accountant - potentially all three. Because it’s such a personal thing, and you’re going to want to make sure that the things you do are going to be right for you and your family.

I won’t go too much into trust because they’re another incredibly complicated area, solicitors can help you with those. But examples like that illustrate the complexities within the system and the importance of focusing on your individual circumstance and doing the right thing for you.

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Kyle Caldwell: I completely agree, but I think before you get financial advice, it’s important to do your own research and to go into it with your eyes wide open. But, as you said, it’s a very, very complicated area, and I do think people can definitely benefit from tax advice, particularly related to inheritance tax.

Craig Rickman: Absolutely. That’s the thing, if you’re reading up about it, you can identify that you’ve got a problem and potentially how big that problem might be. So, then you know there’s a pressing need to go and speak to someone about it.

The other tricky thing around this is that the tax rules change, inheritance tax rules change. We’ve seen thresholds have been frozen since the late 2000s, the tax-free threshold that we mentioned earlier.

There are big changes to pensions are coming down the track. There have been changes to farms, to businesses that have been introduced this year, to AIM shares. So, the fact that the goal posts keep moving can make things a lot harder as well, but the other point is you’ve got to start from somewhere, and then that’s the point, to review what you’re doing on a regular basis.

Kyle Caldwell: So, we’re going to be moving on from inheritance tax to KIIDs. Don’t worry, I won’t be talking about my own. Instead, I’m going to be talking about the key investor information documents (KIIDs) related to funds.

So, Jane got in touch and says: ‘I’ve been looking at different investments. One of my self-imposed rules is that a fund should have a risk level given on a kid of four or below. I’m 66. I’m trying to avoid taking on too much risk. I’ve also been considering ETFs. But in my research, I’ve found that they tend to have a higher risk rating than a similar actively managed fund. I’d like to understand why this is, and I wondered if it make an interesting subject for your podcast.’ 

I thought this was a great question and quite a challenging one as well. I’ve done quite a bit of research into it, and made some notes. So, in these documents, as Jane mentioned, they give a number to show the risk level of a fund, and they range from one to seven. As you’d expect, one is the lowest risk and seven is the highest risk.

I think they’re useful in the sense that they can help you determine when you’re doing your research, what type of funds fits into each category. So, on the low-risk scale, you’d expect something like a money market fund, which is a cash-like type fund to score one. Then, at the more extreme end, you’d expect something like a fund invested in Latin American shares to score seven. 

However, what I’d say is that you have got to remember that these scores are based on the historic volatility of the funds, so it’s backward-looking. So, there’s no guarantee that a fund that scores three today will stay a three in the future. It could move up to a four or a five, for example. Also, there’s no guarantee that a fund that scores five today will be more volatile than a lower-scoring fund in the future.

However, I do think it’s a useful thing to think about as part of your wider research, but I’d go much further in your research. I’d look under the bonnet and understand how the fund invests, what approach it’s taking, is it investing in a more adventurous manner, a cautious manner, or somewhere in the middle? 

Consider the investment style of the fund. Is it investing in value shares, for example, or growth shares? And consider the type of companies the fund’s investing in. Is it investing in larger companies or smaller companies, which tend to be more volatile over shorter time periods?

Also consider, is the fund manager taking a concentrated approach in terms of owning a small number of shares? Are they owning between 20 to 30 shares, for example, or are they owning lots more shares? Are they owning 60 shares-plus. Some funds actually own 200-plus shares, and they’re a lot more diversified and potentially lower risk than a fund that’s owning a much smaller number of shares. 

I’d also look at what percentage the top 10 holdings in a fund is. If it’s 70% or more, that’s a pretty punchy portfolio. They’ve taken quite a lot of concentration and stock-specific bets, and that can increase the risk of the fund.

What I’d also do is look up a performance chart of the fund as I think this is a very useful way to see whether the returns have been relatively smooth, say, over a five-year period or whether there’ve been quite a lot of bumps in the roads. So, yeah, I think these risk scores on the KIDD documents are useful, but I wouldn’t use them purely in isolation. Anything further to add to that, Craig?

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Craig Rickman: Only something short. In some cases, you can deviate away from your standard attitude to risk. You might think that you’re, for example, a risk level four, but there’s no reason why you can’t take perhaps a bit more risk with some elements of your portfolio because it’s the overall attitude to risk that matters. It’s the overall risk within your portfolio. So, you could invest in things that are a bit riskier that could potentially generate some higher returns.

But if it’s a small part of your portfolio, and you’ve got other assets that are supporting it, then that can still be an option as well. So, you don’t necessarily just have to limit yourself to a maximum risk score for funds across your whole portfolio.

Kyle Caldwell: And to address the point that Jane made in her research, where she saw some examples of ETFs having a higher score than a similar actively managed fund, again, it’s important to look under the bonnet and take each one in turn. Consider how the ETF is investing. Is it offering plain vanilla exposure to tracking, say, the FTSE All-Share or the S&P 500, or is it doing something slightly different? Is it investing in a particular theme, sector or part of the market?

There are some ETFs that will invest only in high yield and dividend shares, for example. Also take a look at how concentrated the ETF is. There are some examples of ETFs having nearly half their portfolio in just a handful of stocks, and that is a higher risk, more concentrated approach than an ETF that has lower percentage weightings and a wider spread of companies. 

I also think - just to finish off - active managers have greater scope and opportunity to invest sufficiently differently from the wider market. And when we have these risk-off periods for markets, they have greater opportunity to own more defensive shares, and they can raise cash.

Whereas if you’re just investing in the market, then the market will fall, and you’ll get the return during that period of however it performs. Whereas an active fund manager in those scenarios and, indeed, over the long term, has the ability to try and add greater value beyond the returns that you can get from an index fund or an ETF. 

Of course, there’s no guarantees, and the data shows, if you’re looking at averages, the average fund manager doesn’t beat the average index fund, and that’s across various different regions. But there are some that do outperform, so it’s really important to go away and do your own research and homework to try and find them.

So, Craig, that’s it for our question and answer episode. Thanks for joining me.

Craig Rickman: Thank you very much for having me.

Kyle Caldwell: And that’s all we have time for today. I’d love to hear from more listeners. So, if you have a question that you would like us to tackle in a future episode, then do get in touch by emailing: OTM@ii.co.uk.

I also welcome thoughts on the podcast and ideas for future topics or themes that you would like us to cover. In the meantime, you can find plenty of practical pointers related to personal finance, funds, investment trusts, and ETFs on the interactive investor website, which is ii.co.uk.

Hopefully, I’ll see you again next Thursday.