Transferring your final salary pension into a Sipp? Here’s how to build a robust retirement portfolio

 

The Pensions Regulator has estimated that 80,000 transfers have been made from final salary pension schemes over the year to 31 March 2017, encouraged by the eye-watering transfer sums on offer, and sometimes by a fear that the sponsoring employer may be less than financially sound. Many are taking advantage of the pension freedoms introduced in April 2015 to switch their benefits into a self-invested personal pension (Sipp), which means that from the point of transfer onwards, all of the responsibility for investing the fund is down to the individual.

The first consideration is the asset allocation. The traditional wisdom that a retired person should switch to low-risk assets such as bonds and cash is a hangover from the days when pension pots were used to purchase annuities. 

In fact, there is a real danger in de-risking too early because equities are the only asset that outpaces inflation over a multi-decade horizon. At current life expectancy rates, if you pull back from investing in equities at age 60, then on average you will deny your retirement pot another 21.3 years of potential growth for men and 24.3 years of growth for women. 

‘Even though they have already given up final salary guarantees, individuals still need to be wary of taking too little risk,’ says Patrick Connolly, a certified financial planner at Chase de Vere.  ‘An investment strategy focused mostly on cash, fixed interest and absolute return funds may struggle to keep up with inflation in the long term, which could mean the real value of the pension fund falls. The best approach will be to include equities for growth potential within the Sipp, but also hold other asset classes such as fixed interest and property to provide some degree of capital protection.’ 

Balanced approach

Most advisers suggest a balanced multi-asset portfolio with 40-55 per cent in equities, 20-40 per cent in bonds and 10-20 per cent in property or other alternatives, so that diversification would provide some protection in different stages of the economic cycle. Some also recommend around 10 per cent in absolute return funds for capital protection, and 5 per cent in gold, which doubles as a hedge against inflation – a villain whose presence is likely to expand going forward. 

To obtain this balanced exposure, a mix of funds, investment trusts and exchange traded funds can be used. Typically, it is better to use the cheaper exchange traded fund (ETF) alternative in markets which are considered ‘efficient’ such as the US, where every stock is heavily researched. Active stock-picking funds are generally considered a better choice where there is opacity in a market, such as China or emerging market bonds, or where you know there are ‘roadblocks’ that an active stockpicker could circumvent. 

Generally, the longer the money will be invested, the more risk you can take and the greater the equity weighting, particularly if you do not plan to make big withdrawals from the pot in the next few years. 

For example, a minority of people are transferring final salary pensions into a Sipp for estate planning reasons, to take advantage of the facility to pass pensions on to named beneficiaries in a tax-efficient manner. In the case of death before age 75, pension pots can be inherited entirely tax-free, while death after age 75 will see the beneficiaries of an inherited pension pay tax at their own marginal rate when they make withdrawals from it. 

Pension-holders in such a position may therefore have other sources of income, so they can choose to exhaust other assets that would eventually be subject to inheritance tax; they should leave a high proportion of their Sipp portfolio in growth assets.

For most people, however, the focus is on a fairly balanced spread of assets. There are arguments for investing in multi-asset funds – which hold equities, bonds and sometimes property – to provide ready-made diversification, which may be particularly attractive if your fund is relatively small, say under £100,000. Popular multi-asset choices include the Premier Multi Asset Distribution and Invesco Perpetual Distribution funds.

Another route is to have a passive main central investment, often an ETF or low-cost tracker fund, and select actively managed smaller ‘satellite’ holdings to run alongside it.

‘For equity exposure, investors might consider having a solid core holding such as the Fidelity Index World fund,’ says Ryan Hughes, head of fund selection at AJ Bell. ‘Having a passive core to your portfolio is a great way to build it, as it gives broad-based market exposure at low cost – 0.15 per cent in the case of the Fidelity fund – with the ability to add opportunistic holdings alongside.’ 

Satellite equity

Hughes suggests the Liontrust Special Situations fund could be a good UK option for this more focused satellite equity exposure. ‘The portfolio of around 50 stocks is biased towards medium and smaller companies, making it a strong holding for those thinking longer-term,’ he adds. For income generation, dividend-paying funds are well worth considering. Evenlode Income managed by Hugh Yarrow would be a good choice of fund, as it offers a highly concentrated approach to UK equities that looks very different from the index.

Geographical split is also important. Investors tend to be overweight in their domestic economies, but assets should be spread across various developed and emerging markets. A tilt can be added where the biggest current opportunities lie; perhaps one third in emerging market funds if you believe that growth story will continue. For long-term investors with time on their side, the potential returns on offer could be superior to western markets. 

For broad overseas equity income exposure, the Newton Global Income fund and Fidelity Global Dividend funds aim for attractive income streams without compromising quality. You could also choose a fund with a more specific focus such as Standard Life European Equity Income, JPM US Equity Income or JPM Emerging Markets Income funds; the latter is more defensive than other emerging equity funds. 

Many people currently transferring their final salary scheme benefits may feel that stock markets are expensive at this juncture and a correction could be in the offing. If you are about to transfer into a Sipp, you might be wise to allocate the cash to investments over a period of time, perhaps adding to your equity holdings whenever there is a dip in the stock market. This harnesses the pound averaging principle, allowing you to benefit from market volatility over the long term by buying assets more cheaply than if you were to invest in one fell swoop.

Once invested, taking only the dividend payments from your Sipp is a good way to ensure you do not run down your fund too quickly. ‘Our preferred strategy is to draw only the income that is produced naturally by your investments,’ says Nathan Long, senior pension analyst at Hargreaves Lansdown. ‘Over the long term this should provide a sustainable, increasing income. There is little to no risk of your pension running out, as you are not drawing on your capital. Dividend payments are based on company profits and not the vagaries of the stock market, so are fairly dependable, but they can fluctuate.’ 

For the bond element of a portfolio, our advisers like the Henderson Fixed Interest Monthly Income fund, which currently yields just over 5 per cent a year. Other alternatives include the Fidelity Strategic Bond, Invesco Perpetual Corporate Bond, Rathbone Ethical Bond or Henderson Strategic Bond funds.   

Property exposure

For property exposure, the Henderson UK Property fund and the M&G Property Portfolio are well-liked, while for precious metals there are ETFs or funds such as Investec Global Gold, which invests in a diversified portfolio of mining companies. You might also hold around one year’s worth of income as cash, to ensure you are not forced to sell investments in troubled times. If it is greater protection you want, then you might look at absolute return funds, which aim to guard against falls in markets and even to make profits from market downturns. Good examples are Newton Real Return and Pyrford Global Total Return.   

But as Money Observer has previously highlighted, many fail to deliver on their objectives.  With a balanced portfolio, you will probably be able to withdraw around 3-3.5 per cent annually without depleting the fund too soon.  ‘In the current low-yield environment it is important to be realistic about the levels of sustainable distributions that can be achieved without getting drawn into higher-risk and esoteric pockets of the markets,’ says Jason Hollands of Tilney Group. ‘On a mainstream portfolio of funds with this type of asset mix, it will be nearer the 3-3.5 per cent range than the 4 per cent plus level that many investors anticipate.’

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