In our Money Pit Stop series, we ask an investing expert to give This is Money readers a free portfolio makeover.
Ged and Jo live in York and have owned a welding company for nine years.
Neither have pensions, but they have £100,000 between them in savings Isas, own a home worth £400,000 which is mortgage free, and have a further £250,000 in their business account.
Ged, 45, says he considered purchasing a buy to let property to help fund their retirement, but was deterred by new rules and tax changes introduced over the past few years.
He and Jo, 41, have decided instead to put their money in self-invested personal pensions to grow their wealth, with the aim of both retiring when he reaches 65.
Going for growth: How do you set up a pension from scratch and invest with a 20-year time horizon to retire at 65
They want to open Sipps with £50,000 each to start with, then contribute £40,000 each a year into them, but want to know how and where best to invest.
Ged says they would like medium risk portfolios, as most of their savings will be going into them and they don’t want to be exposed to substantial losses.
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Ged and Jo’s savings and investments
Risk appetite: Medium
Time horizon: 20 years
Funds, investment trusts and ETFs: None
Properties: Home worth £400,000 which is mortgage free
Premium bonds: None
Joe Roxborough, chartered financial planner at independent adviser Ascot Lloyd, writes: Ged and Jo have already made some prudent decisions about how to invest their cash, and now the main choices for them are around how to invest their Sipp monies optimally.
Ged and Jo are right to avoid the buy to let property market as a speculative investment. The punitive tax charges, illiquidity and lack of diversification make this a rather unappealing way to meet their goals, especially if they do not consider themselves property experts.
The Sipps, by contrast, are highly tax efficient, and much of the mental labour can be outsourced.
Joe Roxborough: One person’s ‘medium’ risk can be another’s cautious
Ged and Jo will avoid tax and National Insurance if they make contributions directly from their company into their pensions.
Individual pension savers get pension tax relief based on their income tax rate paid into their pension – effectively making any contributions tax free.
But the financial advantages of channelling payments into pensions via their business, as Ged and Jo will be able to do, can be even more advantageous, as the contributions can come straight from the company itself to their pots, avoiding paying National Insurance and corporation tax for the company.
Not only that, but they will enjoy tax-free growth on investments held within the pension, and a quarter of the fund can be taken back out entirely free of tax.
The remainder can be withdrawn tactically in retirement to complement other income streams and minimise income tax, and lastly, their pension funds will be entirely outside their estate for inheritance tax purposes, all of which are benefits residential property cannot match.
A Sipp can also be used to purchase commercial property, which might of interest to some investors who would like the pension tax benefits but prefer an investment into bricks and mortar.
Although residential property cannot be purchased and held within a pension, this might be a good solution for some investors.
How should Ged and Jo approach investing for retirement?
I would always need to question Ged and Jo about their definition of ‘medium’ risk by showing a few example portfolios.
To avoid subjective words like medium, we use a scale of 1-10 and show the past performance, asset allocation, and potential volatility of each portfolio in the 4-6 region, for instance, and compare this to a common metric like the FTSE All-Share perhaps.
One person’s medium can be another’s cautious.
A 20-year time horizon allows Ged and Jo to consider most investment opportunities as they can ride out volatility, and drip-feeding money into the Sipps by either monthly or annual contributions means a smoothed approach, both of which are useful for reducing volatility in their long-term retirement planning.
As they approach retirement, they may approach risk differently as well, and given their age difference this may be apparent in the way they want to invest.
How much cash should they hold outside their pensions?
Ged and Jo plan to move £100,000 currently held in cash Isas into pensions. However, depending on their spending level and possible emergency requirements, we would recommend keeping 6-12 months of their current expenditure in cash.
They could also consider investing some of their savings outside a pension, in a stocks and shares Isa.
This would mean tax-free growth to complement their retirement planning, but give them immediate access to that money too should it be needed, unlike with their pensions which will be locked up until they reach age 55.
There is a limit on how much you can put in a pension each year and still qualify for tax relief from the Government. The annual allowance is currently £40,000.
But it is gradually reduced from £40,000 to £10,000 for those earning between £150,000 and £210,000 a year.
Where should Ged and Jo invest?
We would need to discuss the types of investments Ged and Jo would want to hold.
For instance, would they prefer index tracking funds which offer lower fees but no expert oversight, more traditional ‘active’ funds that look to beat the markets, or a combination of the two.
As with many things in life, there are no ‘right’ answers, so a discussion about the pros and cons of each would be needed.
Index trackers offer lower costs but don’t have a fund manager who can switch up investments to mitigate losses if markets look likely to fall, or actually do.
Active funds have higher fees, but the expert management can potentially offer better returns net of such costs.
Perhaps most critical would then be asset allocation – this would vary over time given their 20-year-plus time horizon and will also depend on Ged and Jo’s attitude to risk.
An example of asset allocation for a long-term investor with a risk grade 6 portfolio (on a scale of 1-10, with 10 being the highest risk) would be as follows.
Source: Ascot Lloyd
Within each sector, further fund selection would be needed, depending on preferences and research.
Once selected, the funds should be left alone for the most part and not switched out too often, with rebalancing done on either a six monthly or annual basis, to keep in line with their ideal asset allocation.
The funds above are examples in each sector, and not formal recommendations, but give an idea of how a portfolio could be built.
The information provided by our expert is for the purposes of this article and is not personal advice.
If you are at all unsure of the suitability of an investment for your circumstances please seek advice.
Nothing in this response constitutes regulated financial advice. Published questions are sometimes edited for brevity or other reasons.
What about the state pension?
The new full state pension is currently worth £168.60 a week and around £8,800 a year, writes This is Money.
This income is guaranteed from state pension age until you die – unlike pension pots built up through investments, which will be exposed to financial market risks during retirement years unless you use the money to buy an annuity.
Making sure your National Insurance contributions are paid up enough to qualify you for the state pension is therefore an important aspect of retirement planning.
You need to have 35 years of contributions to get the full state pension. Parents or grandparents looking after children aged up to 12, and people with other unpaid caring responsibilities, can get valuable credits that count towards their NI record.
If you are self-employed, you pay Class 2 NI contributions if your profits are above a set level (£6,365 in 2019-2020), and both Class 2 and Class 4 NI when your profits rise above a higher level (£8,632 in 2019-2020). Read more here.
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TOP SIPPS FOR DIY PENSION INVESTORS