In this series we are breaking the subject of income investing down into manageable chunks.
So far, James Norton senior investment planner at Vanguard, has explored the role of dividends and interest, why investors tend to focus on obtaining a high income and how chasing higher yield can leave your portfolio exposed.
In this, the final part, Norton delves into how to maximise your chances of investment success by managing a portfolio for total return.
The cost of an investment can have a significant impact on your take home return according to James Norton of Vanguard
What should the portfolio invest in?
In the last article we warned on the risk of holding investments just because they pay a high income. So what should you invest in?
At Vanguard we believe the answer is simple. For most investors it will be a mix of shares and bonds, accessed at low cost and providing high levels of diversification.
The exact proportions of each depends on your attitude to investment risk, which for most people will fall over time.
When in retirement, portfolios are less able to recover from the inevitable market downturns so some caution is wise.
But, equally, some equity exposure is important as it should help your portfolio to continue to grow.
How do the numbers work?
Let’s take a hypothetical example and assume you have an investment portfolio of £300,000 and you need a gross (before tax) income of £12,000 each year, which works out at 4 per cent of your portfolio value.
The portfolio may generate income of £4,500 through dividends and interest. It’s a good start, but well short of the target income. So simply sell holdings to fund the additional £7,500.
Many investors will instantly recoil from such as suggestion. However, remember that, over the long-term, well-diversified portfolios have grown in value.
Let’s assume the portfolio rises by 7 per cent in a given year. 1.5 per cent of that has come from income (the £4,500 mentioned above), which leaves 5.5 per cent from growth.
For our £300,000 portfolio, that means capital growth will be £16,500. You only need £7,500 to reach your income target. So, at the end of the year, the portfolio would be worth £309,000.
In fact, in this example you only need to generate 2.5 per cent of capital growth to be able to take your £12,000 income and still maintain a balance of £300,000.
What happens when stock markets fall?
Of course, none of these returns are guaranteed and there will be some years when markets fall.
What do you do then? You follow the same process.
The investments are still likely to generate dividends and interest, even when markets go down.
Sell the value of holdings you need to fund your annual income requirement. The difference is that the portfolio will be worth less at the end of the year.
This is no different from a portfolio with high income products that may well fare worse in a falling market.
For some investors, a portfolio that gradually falls over time doesn’t matter, and could be considered a good use of funds.
However, for others, maintaining the capital is important. If that’s the case, you need to have the flexibility to alter your income.
If portfolios rise strongly you build up a natural buffer which will offer some insulation if markets fall. However, if they fall too far, you may have to reconsider the amount you withdraw.
The tax rules around income can be complicated, especially when dealing with pensions. Personal circumstances add further complexity when considering the order of taking income from pensions, ISAs and taxed investments.
However, when looking at a general account in isolation, taking income by selling units will be tax efficient for most investors. In the above example, the sales would be tax free as they fall within the current capital gains tax allowance of £11,700.
How often should I sell?
The total return approach takes some work, but not a lot.
Many investment platforms can set up monthly sales and transfer the required amount into your account.
Another technique is to sell holdings once a year and transfer the proceeds to your bank account.
The right approach for you will largely depend on personal preference, platform functionality and keeping costs down.
What about cash reserves?
One of the biggest dilemmas facing those who are taking an income from their portfolio is how much cash to hold.
In retirement, as in your working life, you will need a cash buffer or rainy day fund.
Three to six months’ income is a good starting point for most people, but for others it may be higher.
Remember, although it’s volatile, over the long-run the stock market has risen, so holding too much cash can be a drag on performance.
And finally, let’s remember costs
At Vanguard we are always passionate about the impact of costs.
Cost is one of the few things that investors can control. Investment return is hypothetical, but taxes, fund and platform costs are actual.
Costs impact those in the accumulation phase and retirees taking income from their portfolio in the same way. However, the effect of costs is more transparent for those seeking income.
Taking the £300,000 example above, a portfolio of high-cost active multi-asset funds could easily cost 2 per cent each year.
That’s £6,000 that will either come from capital or income.
Compare that to a low-cost platform and low-cost multi-asset funds where your all-in fee could be less than 0.5 per cent a year. That’s just saved you £4,500.