For people approaching retirement it can be daunting to plan for a change of pace in lifestyle, while the financial side of things can even be more scary. It is, therefore, always worth getting some form of financial guidance or advice around such life-changing events. If you’re not sure, you should seek help from a financial adviser.

In this article, we highlight some of the financial options available and the important issues to consider. We then explore six fund ideas aligned with the goal of generating an income from investments to be taken together with money from the state pension.

For the purposes of illustration, we have created a fictional character called Roy who is aged 61 and is starting the process of winding down from work. He’s now moved to working part-time before planning to retire completely at 66 when he will start to draw his state pension.

Roy has paid off his mortgage and debts and from age 66 is looking to live off an effective salary from investments and the state pension combined of £30,000 a year before tax. This would produce an after-tax pay of £25,615 a year.

He wants to generate an equivalent income for the period from 61 to when he fully retires. Roy’s new three-day working week pays a salary of £20,000 (£17,264 after tax and national insurance). This leaves him £8,351 short of his goal.

Roy already has £300,000 in a self-invested personal pension pot which generates around £10,000 in dividends every year.

DRAWDOWN OPTIONS

Roy will want to consider which retirement income option is the most tax efficient. In general, taking tax-free lump sums rather than taxable income when someone is a taxpayer makes sense.

Advantages of deferring the state pension

It is possible to defer your state pension in return for an uplift in the weekly amount paid.

For anyone who reached state pension age on or after 6 April 2016, the deferral rate is 1% for every nine weeks they defer, or just under 5.8% for every 52 weeks.

That works out at an extra £10.42 a week for people on the full flat-rate pension of £179.60 a week for the 2021/22 tax year or around £542 a year.

The state pension rises every year under current policy at a minimum of 2.5% a year. 

For someone with a state pension age of 66, the point at which they might reap rewards from deferring the state pension could be around age 81.

This suggests that, provided you are in good health, delaying receiving your state pension could pay off financially.

Roy plans to take out enough income each year from his self-invested personal pension to make up the total to £25,615 after tax.

There are three options under pension drawdown rules to consider. The first option is to crystallise the whole £300,000 pension pot and take 25% or £75,000 out as a tax-free lump sum, and move the remaining £225,000 into drawdown. Roy can then use up his tax-free lump sum gradually to top up his salaried income. He will need to add £8,351 to his salary income of £17,264 to give him his target net income of £25,615. This equals a total of £41,755 over five years.

It’s worth noting that once he has ‘crystallised’ his pension pot any future growth from the pension portfolio cannot earn future tax-free lump sums.

This is probably not the ideal option for the 61-year-old because he only needs access to £41,755 of the tax-free portion over the next five years, not the whole £75,000. Roy will need to decide how to invest the remaining lump sum.

It would make more sense to just release the tax-free cash needed now rather than the whole entitlement.

This would allow the remaining fund, including the unused tax-free portion, to continue growing over the long-term with some tax benefits. For Roy’s purposes the best way to achieve this goal is to opt for a partial drawdown.

Under this option he could elect to take £8,351 every year for five years tax free. So, he needs to do some reverse maths.

The 25% tax free element required each year is £8,351. That means crystallising £33,404 a year, paying out £8,351 as a tax-free lump sum and moving £25,053 into drawdown. This can be left invested until needed.

A third option is to take an ad-hoc lump sum which in pension industry jargon is called an uncrystallised fund pension lump sum, or UFPLS for short.

Under this option 25% of the lump sum is tax free, and 75% is taxed as income. To give Roy a combined lump sum of £8,351 (after tax), he would have to take £9,825 each year as a UFPLS.

To recap, our 61-year-old can enjoy the benefits of their previous income while working part time. The next step is to make sure the portfolio of investments is fit for retirement.

By the point at which Roy retires his pension pot might have seen enough capital growth from his remaining investments to take the total value back to £300,000, even after the withdrawals when he was working part-time.

We are assuming that retiring at the state pension age is necessary to enjoy a comfortable retirement, but in a seperate box we also discuss the financial benefits of delaying taking the state pension.

INVESTING IN RETIREMENT

Historically most of us would have used our pension pots to purchase an annuity, offering a guaranteed income through the course of our retirement.

However, with annuity rates extremely low and greater flexibility now available, many are taking control of their own destiny and remaining invested in retirement.

The new full state pension for the 2021/22 financial year provides £179.60 a week or £9,339 a year. For many people that will be an important component of their overall income in retirement.

For the second part of this article, we will look at how a 66-year-old might want to structure their retirement portfolio and manage withdrawals at retirement. We have assumed a starting pension pot of £300,000 and a target of earning approximately £30,000 a year before tax from investments and the state pension.

A 66-year-old could take £5,000 as a tax-free lump sum and £15,000 of taxed income a year via the partial drawdown or UFPLS routes. As a reminder, the state pension could provide £9,339 a year – and most likely more in the future thanks to annual increases by the Government.

MANAGING THE PORTFOLIO

We have produced a table that shows how a £300,000 portfolio might be managed in order to meet the desired annual income level. It assumes 5% capital growth and 3% dividend yield each year.

As the table shows, the dividend income of the portfolio is £9,450 for the first year and £12,600 of capital is withdrawn from the pension to achieve a pre-tax income of £22,050.

Over time the percentages taken as capital change to offset the fact that a shrinking pot of money will produce a smaller stream of income. By doing this, one could still maintain roughly the same level of overall income a year from the pension pot (capital taken and dividends).

The growth rate of the portfolio partially offsets the money drawn from the fund via dividends and capital, resulting in the value of the fund falling around 2% a year.

It really comes down to individual risk appetite and financial needs later in life that determine the amount of capital that you draw from the pension and how much is left for future generations.

It’s worth remembering that when you die your remaining pension can be passed on to named beneficiaries usually free from inheritance taxes. If you die before the age of 75, no income tax is paid by your beneficiaries, but remember that the majority of people die after the age of 75.

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Five investment ideas for a drawdown pension

For this feature we are focusing on actively managed funds and investment trusts, but future articles will consider passive investments and individual shares that might suit a drawdown portfolio.

Although security of income and low risk are the watch words for a portfolio serving someone in retirement, according to ONS data in September 2020 life expectancy at age 65 years was 18.8 years for males and 21.1 years for females.

This means that some growth element is also desirable in a portfolio if only to maintain values in real terms. Even with inflation running at current low levels of sub-2%, over long periods it can eat into the spending power of your investments.

Growth and reliability of income is therefore just as important as the level of income. We have chosen a mixture of funds which reflect these characteristics.

The following funds specialise in aiming to provide income, defensiveness, inflation protection as well as growth, providing good overall diversification.

 

TB Evenlode Global Income 

Fund (BF1QNC4)

The £1.2 billion fund invests globally in large cap names with an emphasis on providing income. Lead manager Ben Peters has managed the fund since inception in 2017 and has also worked on the Evenlode UK Income fund since 2009 which follows the same investment process.

Chris Elliott joined Evenlode in 2015 and became co-manager of the fund in 2017. The team seeks to buy companies with high profitability, low financial gearing and low  capital intensity.

The idea is that this process leads to a portfolio composed of quality stocks which can benefit from compounding of earnings as well as paying a growing dividend.

The fund has delivered a three-year compound annual growth rate of 12.9% a year, just below the MSCI World Index return of 13.4% a year, but above the peer group return of 9% a year. Recent underperformance can be explained by its quality-focused investment style being out of favour.

The fund has an ongoing annual charge of 0.85% a year and trailing annual dividend yield of 1.97%.

 

Aberdeen Standard European

Logistics Income (ASLI) 116.5p

Yielding 4.3% and trading at a modest 1.1% discount to net asset value, Aberdeen Standard European Logistics Income (ASLI) might appeal to someone in retirement.

It invests in European warehouses – a space which is benefiting from the shift to online shopping which has been accelerated by the pandemic.

While this market is quite mature in the UK, in mainland Europe the growth of e-commerce is at an earlier stage which should have positive implications for valuations and growth of related property investments.

The investment trust’s rents are inflation-linked, providing protection against rising prices and the company completes most of its deals off-market, supported by having teams on the ground and strong relationships with potential tenants.

While one of its more significant tenants, Office Depot in France, recently entered administration, it continues to pay rent and the trust is confident about re-letting the space should it need to.

 

The Merchants Trust (MRCH) 513.1p

With a history stretching back to 1886, this £630 million trust has navigated through most market conditions, from wild booms to crushing busts, all while sticking to its value-oriented approach.

Manager Simon Gergel strives to provide investors with a higher-than-average level of income and income growth through investing in higher yielding UK companies.

Over the past five years the trust has delivered an compound annual growth rate in net asset value of 10.7%, slightly above the Morningstar UK Large Cap category return of 9%.

The biggest holdings include pharmaceutical firm GlaxoSmithKline (GSK), tobacco stocks Imperial Brands (IMB) and British American Tobacco (BATS) which make up around 17% of the trust’s assets.

Oil companies Royal Dutch Shell (RDSB) and BP (BP.), and financials St. James’s Place (SJP) and IG Group (IGG) are other big holdings.

The trust has a trailing dividend yield of 5.3% and an unbroken 38-year record of increasing the payout. The ongoing charge is 0.61% a year.

 

Jupiter Asian Income

Fund (BZ2YMT7) 153.6p

The £813 million fund aims to beat the FTSE All World Asia Pacific Ex-Japan Index with a focus on income and income growth over the long-term.

The fund is looking to deliver 120% of the benchmark dividend yield. Manager Jason Pidcock believes dividend yield is an underappreciated element of shareholder valuation. The trailing 12-month yield is 3% and dividends are paid quarterly.

Pidcock is looking for companies with strong management and a sustainable advantage, allowing them to generate cash and fund dividend payouts.

Top holdings include Taiwan-based Hon Hai Precision Industry which is engaged in the provision of connectors to the communications industry. Korean electronics giant Samsung Electronics as well as UK miner BHP (BHP) also feature in the portfolio.

Over the past five years the fund has delivered a compound annual growth rate of 12.7% a year compared with 10.4% for the benchmark. The ongoing charge is 0.98% a year.

 

Allianz Strategic Bond

Fund (BYT2QW8) 130p

The rationale for considering this £3.1 billion strategic bond fund is the flexible mandate which allows the managers to dial up risk when economic conditions are attractive and preserve capital during more difficult times.

Managed by Mike Riddell and supported by the deep bench of analysts at Allianz Global Investors, the fund is run to ensure that it behaves as a counterweight to riskier equities by attempting to provide safety when volatility rises and markets fall.

The fund has a trailing dividend yield of 4.2%, with dividends paid twice a year. It seeks to outperform the Bloomberg Barclays Global Aggregate Index.

Over the past three years the fund has delivered a compound annual return of 13.1% compared with 3.1% for the benchmark according to Morningstar data.

The fund has 56% of its assets in the highest quality companies compared with just 20% for the index. The annual ongoing charge is 0.42%.

 

First Sentier Global Listed

Infrastructure Fund (B24HK55) 216.7p

The huge boost to infrastructure spending outlined by US president Joe Biden and similar initiatives across the world bodes well for funds focused on this specialist sector.

The £1.7 billion First Sentier fund seeks to outperform the FTSE Global Core Infrastructure 50/50 index by investing with capital preservation at its heart to find high quality mispriced companies.

The experienced team of Peter Meany and Andrew Greenup have managed the fund since inception in 2007 and are supported by a wider team of portfolio managers and analysts possessing dedicated sector knowledge.

The fund has delivered a five-year compound annual growth rate of 8.6%, just ahead of the benchmark return of 8.5% according to Morningstar data. The trailing 12-month dividend yield is 2.5%.

The largest holdings include American Tower, which is a US specialist in operating communication towers, as well Australian toll-road operator Transurban Group and US energy group Dominion Energy.

The fund has an ongoing charge of 0.8%.

DISCLAIMER: Shares’ editor Daniel Coatsworth has a personal investment in Allianz Strategic Bond, Evenlode Global Income and First Sentier Global Listed Infrastructure Fund referenced in this article.

Part of this article is based on a fictional situation to provide an example of how someone might approach investing. It is not a personal recommendation. It is important to do your research and understand the risks before investing.

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