Can we supplement our retirement income by £23,000 a year?

Mahesh is 60 and his wife is 59. He is a self-employed consultant and earns £90,000 a year and his wife is an NHS administrator. Their two children have recently started work.

Their home is worth £600,000 and mortgage free.

“We want to generate a combined income of £48,000 a year after we retire at age 67, maintain our spending power, and enjoy more holidays and travels abroad,” says Mahesh. “I intend to continue my business until at least my state pension age of 67, but reduce my workload over the next year meaning that my annual earnings will fall to £45,000-£50,000.

“My wife will retire next year with an index-linked pension that starts at £7,500 a year and a tax-free lump sum of £45,000. We will both qualify for a full state pension. So I estimate that there will be a shortfall of around £23,000 per year, before inflation, between our pensions income and target retirement income. We plan to cover this shortfall with our individual savings accounts (Isas) and my self invested personal pension (Sipp). 

“I contribute £40,000 per year  to my Sipp but, as our disposable income will reduce from next year we will have to rethink how much we  put into them each year. Also, my Sipp’s value of about £1.45m is over the pensions lifetime allowance [of £1,073,100] so dealing with this problem is one of my main priorities. About 60 per cent of my lifetime allowance was crystallised five years ago as the 25 per cent tax free cash entitlement. We used this to fund various projects at the time.

“We also want to reduce our estate’s inheritance tax (IHT) liability as we have assets worth about £2m exposed to this. These include two discretionary trusts worth £300,000 in total which we opened in 2019. So although we would like to continue to use our full annual Isa allowances of £20,000 a year, we might redirect future investments into an IHT efficient vehicle.

“We have also built up Isas for our children which are each worth about £250,000. These should help them to buy their first properties in the next few years. These include Lifetime Isas which we fund up to the annual £4,000 limit every year. Doing this also helps with our IHT planning.

“We have mirror wills in place but no Lasting Powers of Attorney.

“I find investing interesting and have been building portfolios for nearly 40 years, but it does not interest my wife. I try to invest in the shares of high-quality businesses and keep them for years or decades. I am not interested in short-term tactical trading as it adds to investment costs and there is no certainty of success.

“I also invest in a few funds which take the same approach. Some of my direct share holdings are also held by these funds which increases our portfolio’s concentration risk. But this is a consequence of investing in quality businesses as the investable universe is constrained. I have tried to address this to a limited extent by also holding low cost index tracking funds, to which I contribute £300 a month.

“I would also like to increase our exposure to environmental, social and governance investing funds.”

Mahesh and his wife’s total portfolio

NONE OF THE COMMENTARY BELOW SHOULD BE REGARDED AS ADVICE. IT IS GENERAL INFORMATION BASED ON A SNAPSHOT OF THESE INVESTORS’ CIRCUMSTANCES.

Chris Dillow, Investors’ Chronicle’s economist, says:

This portfolio can easily finance your income shortfall. The amount of £23,000 a year is equivalent to less than 1 per cent of your non-property holdings. So even with mediocre returns, you should be able to take all the income you want and still see your capital grow.

I stress here that what matters is the portfolio’s total return. You can create your own dividends simply by selling some holdings each year.

Buying income stocks such as miners or housebuilders would mean that you take on more cyclical risk while some stocks offer a high yield to compensate for a lack of growth. But neither approach has paid off well in recent years. This might change, but you should only buy income stocks if you believe that this will happen rather than because you need income. And you can get that elsewhere.

Your Sipp’s value is above the pensions lifetime allowance so, I would delay putting more into it until you have consulted a financial adviser. 

You are right to avoid short-term tactical trading. But holding stocks for decades creates some challenges. Very few companies can survive and thrive in the forces of creative destruction that tend to undermine incumbent firms. Most companies’ profits and share valuation are eroded by competition. So long-term investors need companies which have what US investor Warren Buffett calls economic moats – sources of monopoly power. But very few firms have these. Hendrik Bessembinder, professor of competitive business at Arizona State University WP Carey School of Business, has estimated that just 1.3 per cent of companies account for all the stock market’s increase between 1990 and 2018.

If you want to avoid oil and tobacco stocks on ethical grounds, your choices are even more limited. But given this tight constraint, your holdings are reasonable. However, investors might have bought fully into the theme of economic moats and pushed up the valuations of such shares to the max. Investment fashions can change.

There is also political risk. Even in the US, there is a history of occasional backlashes against strong monopoly power. Apple (US:AAPL), Facebook (US:FB) and Microsoft (US:MSFT), for example, might be at risk from regulatory threats such as break-ups or changes in intellectual property law.

And such stocks are now mature and offer little growth – perhaps especially little compared to what is priced in.

These dangers don’t just apply to your direct holdings, but also funds which hold moat stocks such as Fundsmith Equity (GB00B41YBW71) and Lindsell Train Global Equity (IE00BJSPMJ28).

For these reasons, you are right to diversify – especially into index funds. If you hold actively managed funds for a long time charges mount up – the power of compounding can work against you.

But you might want to consider some private equity or venture capital investments. It’s possible that these will offer more long-term growth than listed equities, and they might be a good way to invest in green investments. But because they can be illiquid they must be regarded as long-term investments.

Kay Ingram, chartered financial planner, says:

You have investments worth about £2.89m so achieving the retirement income you need should be fairly straightforward, especially as over £900,000 is invested in Isas which can provide tax-free growth and income. The next seven years are an opportunity to make your portfolio as tax efficient as possible and reduce the concentration of stocks.

You could also segment your Isas and Sipp funds into buckets, and invest each according to their purpose and the timeframe over which you are likely to need access. Your Isas should cover your income shortfall and your Sipp should be left as a tax-free inheritance.

You can continue to add to your Isas over the next few years by selling investments outside tax wrappers – as much as can be offset against your annual annual capital gains tax (CGT) allowance of £12,300 each.  

Your buy-and-hold strategy may minimise dealing charges, but unless gains are realised within annual CGT allowances those savings could eventually be wiped out by a substantial CGT bill.

Cash in your NS&I Premium Bonds to enable you to invest an additional £20,000 per year in each of your Isas, initially for growth and to provide you with income after age 67. The odds of winning even a £25,000 prize are only 34,500 to one and Premium Bonds are unsuitable for those seeking inflation beating returns or an income. 

This would leave £65,000 in accessible cash savings which is almost three years’ worth of your £23,000 income shortfall – an adequate cash reserve which should ensure that you don’t need to access your investments early in your retirement.

Leave your Sipp invested for as long as possible. It’s the most tax-efficient investment wrapper you have, other than the fact you may have to pay the lifetime allowance charge. Investments within Sipps do not incur CGT and you can leave it to your chosen beneficiaries free of IHT.

The lifetime allowance is not a limit on the amount which can be held in a pension. Savers can accrue unlimited funds in UK registered pensions, with a one-off tax levied on the amount over the lifetime allowance, when certain trigger events occur. These include starting drawdown, taking a tax-free lump sum, transferring a pension to an overseas scheme, death before age 75 and reaching age 75. And you have control over if and when the first three events happen.

The tax charge on the excess above the lifetime allowance is 25 per cent if it remains invested or is withdrawn as income, which will also be subject to income tax. Or 55 per cent if the excess is drawn as a lump sum.

You may be eligible for a higher personal lifetime allowance if, on 5 April 2016, your Sipp was valued above £1m. Individual Protection 2016 enables the value at that date, up to £1.25m, to be registered with HM Revenue & Customs (HMRC) for a higher personal lifetime allowance.

After age 75 there are no further lifetime allowance charges. Any remaining pension fund on death can be passed on multiple times to future generations, IHT-free and before probate is granted. The inherited pension doesn’t count towards the beneficiaries’ lifetime allowance. Income withdrawals made by the Sipp owner or a subsequent beneficiary are taxed as their income.

If you die before age 75, the lifetime allowance charge is triggered but your beneficiaries don’t have to pay any income tax on withdrawals, or any other taxes.

If your wills leave everything to each other and then your children, there will be no IHT to pay on the first death as transfers between spouses are exempt. When the funds transfer to your children IHT will be due on the excess over the nil rate bands of £325,000 each and residence nil rate bands of up to £175,000 each.

As your joint estate exceeds £2m, the residence nil rate band will be reduced proportionately by £1 for every £2 over £2m, so to nil on estates over £2,350,000. If your wealth continues to grow, consider investing in assets which are exempt from IHT by qualifying for business property relief after two years ownership. This may include some Aim listed stocks although not all companies quoted on this market qualify. 

Establish a record of the lifetime gifts you have made, and determine which exemptions and allowances they are eligible for. Savings made out of surplus income are exempt as long as they are regular and don’t reduce the donor’s standard of living.

Other gifts may be taxable or until seven years after the date of gift. Having a record can make it easier to deal with queries from HMRC when arranging probate. The onus is on you to prove that lifetime gifts are exempt or partially exempt.

Involve your wife in the management of your money to build up her knowledge and confidence. You should both arrange a lasting power of attorney so that if you are incapacitated the attorney can deal with your investments on your behalf. Without this, it could be impossible to make changes to the investments without applying to the Court of Protection – a lengthy and expensive process.

Also consider an exit plan in case you lose interest in investing. You could secure a guaranteed income by buying an annuity from an insurance company to meet your income shortfall. Although it is likely to be poor value in the short term, if interest rates rise or your health deteriorates an annuity could offer a stress-free income.