Our three income portfolios and how we constructed them
It’s clear that in the current era of low returns from both cash savings and annuities, many retired people who lack final salary pensions will need to invest their retirement savings pot in an income portfolio to get the income they need. Cash is not a viable option and neither are annuities.
Accordingly, this website suggests three possible income portfolios for retired investors.
You may be wondering why we have suggested three portfolios rather than just one. The answer is that the portfolios have different aims to reflect people’s different circumstances and needs.
If you have no children or other close relatives, for example, you can concentrate solely on your own need for income during your life. The aim here may be to use all the money in your pot to fund your retirement and not leave any cash unspent when you die. This is the purpose of our high-income portfolio, which targets an annual income of 5% of your initial pension pot, rising with inflation.
If, on the other hand, you are determined to leave a substantial legacy, your portfolio, and the rate at which you make withdrawals, will be different. Our inheritance portfolio aims to maintain the value of your assets in real terms while paying an income of 3% of the initial pot, again rising with inflation. This point about maintaining the value of assets in real terms means that the assets retain their buying power after taking account of inflation.
Some people would like to leave a legacy, but not at the expense of their own income in retirement. Our compromise portfolio, which stands midway between the other two, is for them; its income target is 4%.
Using investment funds
In constructing our retirement income portfolios, we have used mostly funds. These are professionally managed baskets of shares and other assets. All of the funds we have selected are well-known, mainstream funds and will be available from major platforms.
We have aimed for simplicity and ease of administration, which means keeping the number of funds in each portfolio to a minimum. Nonetheless, we cannot rely on a very small number of funds – such as just one or two – because this would expose the portfolios to the skills and choices of a small number of fund managers.
It’s safer to opt for a wider range of funds, to reduce the risk of one manager performing badly. For this reason, as well as to achieve a mix of assets, each portfolio consists of eight holdings.
There are a few admin points you need to understand about funds in order to build the portfolios correctly and feel confident in what you are doing. These points are covered below.
Why do the portfolios hold funds rather than investing directly?
In theory we could have chosen a basket of shares to invest in directly, rather than investing in funds and leaving the job of choosing individual investments to fund managers.
But experience suggests that many find the task of managing a portfolio of shares more daunting than managing funds.
Although the funds we have chosen should be suitable to hold for a very long time, perhaps even for your entire retirement, it would be wise to reassure yourself of their continuing suitability periodically. We explain how to do this elsewhere on this website, as part of our comprehensive programme for ensuring that your portfolio remains on track.
Unit trusts, investment trusts and share classes
We have chosen to build our portfolios with two types of fund.
The first, which may be called a unit trust, open-ended fund, open-ended investment company, or even just fund, is simply a collection of shares (or other assets, such as bonds) chosen either by a fund manager or by an automated process. The price of a unit in the fund is, put simply, an average of the prices of its component shares or other assets.
The second type, called an investment trust (or sometimes an investment company or closed-ended fund), is similar – it is also a collection of shares, bonds and other assets. But in this case the fund is structured as a limited company in its own right and the shares in that company are listed on the stock market.
There are several other differences between unit trusts and investment trusts, many of which are of little relevance to this website. One important distinction, however, is that platforms will always charge you a fee when you buy or sell an investment trust (for example, Hargreaves Lansdown charges £11.95 and AJ Bell £9.95), whereas many platforms do not charge to buy or sell unit trusts, or charge less.
We have borne this point in mind in our attempts (see Step 2) to identify the most cost-effective platforms and have minimised our use of investment trusts in the high-income portfolio, where regular sales of each holding are envisaged.
As investment trusts are quoted companies, they have a stock market ticker symbol, which acts as a unique means of identification. Other funds are identified by name (or with long numbers such as ‘ISIN’ or ‘SEDOL’ numbers).
Ordinary funds, as opposed to investment trusts, also tend to come in varieties called ‘share classes’ and sometimes it is important to buy the right class (choosing the wrong one can mean paying extra every year). We have indicated the correct share class where appropriate.
There are often good reasons to choose one type of fund in preference to the other. For example, for our exposure to commercial property we have chosen investment trusts rather than unit trusts. This is because the latter face a problem when it comes to property: investors in a unit trust can ask for their money back at any time, but to raise that money by selling the funds’ property assets is likely to take the fund manager many months.
This problem was in evidence after the EU referendum in 2016, when investors turned away from commercial property en masse in fear of a downturn in the UK property market. Almost all the property unit trusts were forced to suspend redemptions as investors tried to get their money out and the funds tried to sell their property assets to fund these requests.
Investment trusts do not face this problem because investors who want their money back have to find another investor to buy their shares. In practice this means selling on the stock market via a stockbroker. This market never dries up, although in periods of turmoil you can expect demand for the property fund’s shares, and thus their prices, to fall.
Passive tracker funds versus active funds
All the funds in our portfolios are run by professional investors employed by fund management firms. But recently another type of fund has made great strides: these are funds that do away with detailed analysis of individual shares and instead simply buy all the stocks in a particular index, such as the FTSE 100.
These automated funds are called ‘tracker’ or ‘passive’ funds.You might imagine that avoiding any attempt at share selection would be foolhardy and would result in a fund that held many unsuitable investments. But the evidence is that many traditional funds fail to do any better than these dumb passive funds, despite the efforts made by their professional managers.
Tracker funds have the advantage of being cheaper than traditional funds run by human managers and many investors argue that even a good manager may struggle to overcome this cost difference.
The debate about the relative merits of the two types of fund is huge in the investment world and no consensus has yet been reached. Some are vociferous in their belief in one type or the other. Others are more measured and believe that there can be a place for both, with the decision for each investor depending on factors such as investment goals, the investment time frame, the types of asset considered and how much time and effort they want to devote to choosing and managing their investments.
We are in the pragmatic camp and would be happy to include tracker funds in the portfolios if we believed that they could carry out the task expected of any of the existing actively managed funds. Currently we are not convinced that this is possible.
Income versus accumulation units
One source of confusion for anyone who buys an investment fund for the first time is that they will be confronted with a choice between two varieties, ‘income’ (inc) or ‘accumulation’ (acc).
The distinction relates to what the fund does with the income it receives on its assets, such as dividends from shares, interest from bonds or rent from properties. If you buy the income version of the fund the income is paid to you at regular intervals – such as twice per year, quarterly or monthly – whereas with the accumulation type the fund manager retains the income and reinvests it.
You will therefore want the income version of the funds, as you are creating your portfolio to pay you an income. For an explanation of how to withdraw your income from your portfolio, see Step 4.
Our portfolios also hold some investment trusts, which will automatically pay income to you, as opposed to reinvesting it. In other words, you don’t need to worry about the distinction between income and accumulation units with investment trusts.
Now that you understand the essential aspects of the funds within the portfolios, we will explain how we went about choosing the funds to include in the portfolios.
How did we choose these funds?
With literally thousands of investment funds to choose from, how did we choose the funds in our portfolios?
As the adverts always say, “past performance is no guide to the future”. Just because a fund manager has done well in the past, it does not mean he or she will do well in future. There is luck in investing, just as in any other sphere. You do not want to choose an investment because the fund manager has simply had a recent streak of luck.
So, while we have met and interviewed the majority of fund managers who oversee the funds we suggest, we are not choosing these funds purely on the track record of the man or woman in charge. The track record of the fund – by which we mean a lengthy history of outperforming the wider market – is only one factor.
Another vital factor is the consistency of the approach taken by the manager. When assessing fund managers we look to identify a clear investment philosophy underpinning their approach. We also require evidence that this philosophy has been applied and followed in a consistent, disciplined way over time.
While we believe that some individuals appear to have a remarkable skill for identifying attractive opportunities, we want more than that: we want evidence of a process underpinning their portfolio and the investment decisions made.
Thus it is also important that the man or woman overseeing the fund is part of a wider team, where the whole team is equally committed to the investment approach and equally committed to applying it in a way that is consistent and incorporates appropriate risk controls.
On this basis, we can expect certain fund managers’ approaches to result in generally predictable performance outcomes in certain market conditions. We can expect the funds to continue to perform well even where there are changes in key personnel. This consistency of approach and execution is important for another reason: it can help us decide what funds work best when held alongside one another. There is no single, ‘right’ portfolio selection
Many readers will want to make their own fund choices. You may already have your own portfolio built out of your own knowledge and experience. You may also find guidance or information provided by your chosen investment provider, pointing you towards a different selection of funds.
No matter how much expertise and effort go into choosing a particular fund portfolio, there is no chance that it will turn out to be the very best performer of all the potential combinations (which number in many millions). A more realistic expectation is that the portfolio will produce the income desired along with sufficient diversification to reduce the risk of alarming falls in value.
Many of the funds named in this book form part of the authors’ own portfolios, even though they are not yet retired, and can be expected, assuming that nothing changes, to form a large part of their actual retirement portfolios when the time comes.
Construction of the portfolios
How we chose the mix of assets in the portfolios
The range of assets in all the portfolios includes shares, bonds (which pay interest like bank accounts but can fluctuate in value like shares) and commercial property.
These three types of assets produce income in different ways, which is important because it reduces the likelihood of sharp fluctuations in the income produced by the portfolio as a whole.
Imagine, for example, that an event such as a recession affects the income you get from your shares. But the income from your bonds and from your property funds could well be unaffected. This is because the income paid by bond issuers and the tenants of commercial properties is set in stone by binding contracts, whereas dividends from shares are paid at the discretion of the firm concerned.
Why not just stick to bonds and property then? The reason is that interest from bonds is reliable (as long as they are chosen carefully), but does not rise. The capital value of bonds, taken in the round, is broadly static over the long term too (although short-term fluctuations in the value of some bonds can be marked). The property market moves to its own cycles, which can involve falls in capital values. The dividends from a basket of well chosen shares, meanwhile, have the potential to rise appreciably each year.
As we said, the best approach is to hold a mixture of these assets, so that your income is not too dependent on any one of them. There is more than one way to achieve the intended mix. To simplify the argument, you could buy one fund that invests in shares, one that invests in bonds and one that invests in property. Alternatively, there are funds that hold two of these categories, or all three. We use a blend of these approaches.
Why the portfolios seem similar
You will notice that the same funds appear in two or even all three of our portfolios and that at the time of writing our high-income and compromise portfolios are actually identical, although they could diverge in future.
This is because what the portfolio produces – in terms of the balance between the income taken during retirement and the capital available ultimately to leave to your heirs – depends on how you handle the portfolio, not its composition.
The high-income portfolio, for example, could function very well as the inheritance (capital preservation) portfolio, if less income were taken from it.
How will these portfolios perform?
It would be lovely to think that the portfolios will deliver exactly on the aims we have assigned to them. But markets are too unpredictable for that. The inheritance portfolio, for example, which aims to deliver 3% annual income and preservation of your original pot of money in real terms, could end up producing a much larger sum by the time you die.
With the compromise portfolio, meanwhile, you could find that taking out 4% a year, with the amount increasing every year in line with inflation, erodes the capital to some extent. It all depends on how the markets in general, and the particular investments we have chosen, perform in future.
What we can say is that if markets broadly perform in line with historic trends, the three portfolios should achieve roughly what they are intended to.
If your friends would find this page useful, share it with them using the buttons below left (if you use the email button, ensure you tick "I'm not a robot" before you fill in the other fields).
Do you have a question or would you like to give feedback about this website? Email us at at firstname.lastname@example.org
*Links marked with an asterisk can earn money for this website: the company involved may pay us commission if you follow our link to its website or transact on it. This does not have any effect on what we write.
Nothing in this website constitutes personal financial advice. Its contents represent journalistic research and readers should ensure that any course of action they consider as a result of anything that appears on this website is appropriate to their own needs and circumstances, if necessary with the help of a financial adviser regulated by the Financial Conduct Authority. All investing involves risk: ensure that you understand the risks before you proceed.
Copyright © Richard Evans, 2019-20