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Every week, Kyle Caldwell and guests take a look at how the biggest stories and emerging trends could affect your investments, with practical tips and ideas to help you navigate your way through. Join the conversation, tell us what you want us to talk about or send us a question to OTM@ii.co.uk. Visit www.ii.co.uk for more investment insight and ideas.
Hello, and welcome to our latest On The Money podcast, a weekly show that aims to help you make the most out of your savings and investments. In this episode, we're gonna be tackling questions that have been submitted by listeners. And joining me to provide his expert insights is Craig Rickman, who is personal finance editor at Interactive Investor. Craig, thanks for coming on.
Craig Rickman:Thanks for having me back, Kyle.
Kyle Caldwell:So, Craig, we're gonna start off with a pension related question, which is very much in your wheelhouse. So Veronica emailed, and she said, I'm close to retirement and have a self invested personal pension that's valued at around £250,000. My intention is to go into drawdown, making my own investment decisions as I'm comfortable doing so, and I have all the savings that I can dip into if needed. How much income could I realistically generate to help supplement my retirement?
Craig Rickman:Yeah. I think that's a that's a good point. It is a it's a huge question. It's, you know, it's a situation that pretty much all of us will be well, everyone will be confronted with at some point. Anyone with a defined contribution pension When they reach retirement, it's how do I turn this into an income, not just an income that's gonna support me now, but it's gonna support me in the future as well.
Craig Rickman:And interesting that that that Veronica said that she wants to keep the money invested and and and draw income flexibly. She's happy to do that. It's important to point out that, yeah, that's that's one of the options you have to turn your pension pot into a retirement income. The other, as she notes, is an annuity. We may come back to that in a second, but we'll just park that for now and focus on, you know, the the question that Veronica's asking.
Craig Rickman:So when it comes to drawing retirement income, this is very much a personal thing and it depends on several factors. It depends on, you know, how much income you need. It depends on any other assets that you that you may have, any other forms of guaranteed income, whether or not you're due to receive the state pension anytime soon, whether you're retiring before. So that, you know, there there are lots of different things that can influence how much income you need to draw from your from your pensions. But there are some guides available, there are some rules of thumb, so it might be certainly worth sort of going through one of those.
Craig Rickman:The main one is called the 4% rule which has some other names otherwise known as the safe safe withdrawal rate and the Bengen rule. It's called the Bengen rule because it was developed by an American financial planner called Bill Bengen back in the nineties. So Bengen calculated that if you withdraw 4% of your portfolio every year, uprated annually to take account of inflation, then your retirement part should last at least thirty years. That's what the rule is is is determined. That's when it was developed back in the nineties.
Craig Rickman:Recently, Bengen updated it to 4.7% to take account of sort of a wider range of factors and, you know, updated conditions. So, yeah, he's he's he's thinks that you can you can withdraw 4.7% a year. So that might be a useful guide in in this instance. So, you know, if you've got a part of 250,000 drawing 4.7% every year. So if you thought, well, if it was 5%, that's gonna be 12 and a half thousand pounds a year.
Craig Rickman:So, you know, that might be a sort of a useful starting point. But it's important to note that that is purely a guide to to income, and there are other things that that that people need to think about. But, yeah, might might provide a good point to start with.
Kyle Caldwell:And Veronica didn't mention how old she is, but as you mentioned, at some point, there will be the state pension that you can also utilize as well. However, if you're retiring, say, five or ten years ahead of being able to claim the state pension, then you may need the income generating from your investments to work harder for you in order to meet the amount that you are aiming to generate and help supplement your retirement. And, you know, for me, it's it's, you know, it's getting it's as simple as getting out a pen and paper and working out what how much do I need for essential spending? And in terms of discretionary spending, what you wanna do in your retirement? You know, do you wanna go, you know, certain holidays, have certain experiences, and then work out, you know, what you need to deliver from your investments and your other assets in order to achieve what you wanna achieve?
Craig Rickman:Absolutely that. And I think because there there are sort of other other questions to answer with what to do with your retirement part as well. How how to withdraw the tax free cash element, whether to take that in one hit or whether to, you know, draw draw a a bit every year as part of a, you know, an income tax strategy in retirement. So, there's these you know, these are these are the that's the big decision that that people face, how how to use that pot. But how how much you can draw, yeah, would depend on other things.
Craig Rickman:I mean, if you've got sufficient guaranteed income from elsewhere, so if you've got the state pension as as you noted, but it's it's important to flag that not everyone gets the full state pension. You need to get well, most people need to get thirty five years. People coming up to retirement will need thirty five years of qualifying national insurance contributions to get the full amount. But it's important to factor that in. So if you've got sufficient guaranteed income from other sources, then the withdrawal rates or the amount of income that you can take from your drawdown pot might might be higher.
Craig Rickman:If you're more reliant on it, so if that's gonna provide the bulk of your retirement income, perhaps alongside the state pension, then you might wanna be a bit cautious. But I think that's the important thing is to try and give yourself as much time to plan as possible. So it's you wouldn't wanna be retiring or looking at, you know, your income options in June and retiring in July. You in an ideal world, you you would kinda wanna give yourself more time to plan ahead so that when the time comes, you know exactly how much income you need to be drawing for it to be sustainable throughout your retirement.
Kyle Caldwell:And that's just one half of it, you know, coming up with how much do I ideally want to generate from my investments. The other half is what investments to choose, what to pick, and how to arrange your investments in order to deliver on that goal. Absolutely. And and and back to the point which sort
Craig Rickman:of mentioned annuities earlier, which, you know, Veronica has has said that, you know, that she she doesn't want to entertain, but, you know, that's that's the big decision as well. Do you choose a guaranteed income like you get with annuity that can give you certainty and security but rigid? So with lifetime annuities, the terms you've chosen at outset and there are various ways that you can that you can secure an annuity income, so you can have it rising every year, you can, sorry, rising in line with inflation, you can have the money or the income passed to a spouse or a dependent should you die. So do you want to look at that option or do you want to keep the money invested where you have more flexibility but, you know, there's there's more risk as well because the risk is that you could drain the money too soon if your withdrawals are too aggressive and the investments don't perform as well as as you would hope. So that's another big decision whether to use one or the other, whether to use a bit of both, and that is that that well, that illustrates why it's so important to give yourself some time to to weigh out the options to try and find the right sort of the right solutions for your retirement.
Kyle Caldwell:And just to reiterate what you just said there, Craig, you can do both. It's not an either or decision. It's often pitted against each other, you know, should you go into drawdown versus annuities. It's quite a common tactic for some people to secure their sort of everyday spending through an annuity and then leaving the rest of the pension investors, and some of that can go towards more or go more towards potentially using it for discretionary spending.
Craig Rickman:Yeah. That that can work very well for some people because you have that security. You have that security to to not be relying, like, like, kinda like we were saying earlier, you're not so you're not relying on that on your drawdown pot, absolutely, but you do have a bit of security there. But that said, some people are more than happy to keep the the lot invested and manage manage the pot themselves. Others will be, no, I just I purely want a guaranteed income.
Craig Rickman:I want that security with with all of it, or they might keep a very small amount in drawdown. And that's the that's the the good thing about it is that there's no there's there's no sort of fixed way of doing it. You can have lots and lots of guaranteed income and a bit of drawdown. You could have lots of drawdown and a bit of guaranteed income or half and half. Yeah.
Craig Rickman:You, you know, you get to decide.
Kyle Caldwell:So the next person who got in touch mentioned that they're also close to retirement. So Richard said, I'm conscious that I am heavily invested in the accumulation share class versions of the funds I own. What are the pros and cons of leaving my investments in the accumulation versions over the income versions? So I'll go first with this one. So an accumulation fund share class, what that does is the funds underlying investments, if they pay dividends, then those dividends are reinvested.
Kyle Caldwell:And if you are building your wealth over time and you are set for instance, you're saving towards retirement, then essentially more money is going back into the funds, and then that allows for great a greater benefit in terms of compound returns in which investment returns themselves generate future gains. If you pick the income share class, then all the income that's generated from the funds in a given year, that is then returned to you, and it'll go into your the cash elements of your accounts. So I think if you're investing towards your retirement and you don't need the income, I think in most cases, you're better off with the accumulation version of the fund share class because there's more money working harder for you. However, in retirement, I do think you have to think carefully about which one to pick, And I do think it's down largely to personal preference. If you pick the income share class, then the income is coming sort of automatically to you, and you could potentially build an income producing portfolio that is paying at certain yields or aiming for certain yields, and you could potentially try and just take the so called natural income from the portfolio and try and leave the capital value untouched.
Kyle Caldwell:And this can be very beneficial if we have a volatile period for stock markets because you're given the capital and greater opportunity to grow and recover over time. Whereas if you're opting for the accumulation fund share class versions, then you need to it's it's more, you know, it's more of a manual choice, and there is more work to it as you'll need to decide which funds you're looking to sell down, which fund units you're looking to reduce. So there there's more to it in terms of you're gonna have to make an active choice about which which funds to sell in order to generate the amount of income that you want to take from the investments. But as I said, I think there's no right or wrong answer. I think ultimately, it's in retirement.
Kyle Caldwell:It's it's personal preference. Any further thoughts, Craig?
Craig Rickman:Not really. I think you've you've, yeah, you've you've you've covered that off perfectly. I do yeah. That it's a it's a decision that's a lot easier when you're building wealth for retirement because you yeah. You want the as you say, you want the any income to be added back into the pot and and compound over time.
Craig Rickman:Once you reach retirement, it can become can be a bit more nuanced. It's not just a matter of, you know, switching on or or moving to, you know, distribution share classes and having the income paid out. But as you say, it can be a really useful way of generating the natural natural yield. And for for a lot of people, that's what they want to do with their retirement retirement pots is to protect protect the capital and just draw the income. If if only it were that simple.
Craig Rickman:But, yeah, I think, yeah, that that I guess the point around is similar to what we were talking about with, you know, withdrawal down annuities and annuity and, sorry, and and, you know, taking an income from a SIP, it's it's a personal thing. You just gotta find the right thing for you.
Kyle Caldwell:And I think it's also really important to get the balance right in terms of the type of investments that you own. So I think, you know, for example, if you're at the time retiring at 60, you know, hopefully, you've got, you know, twenty, thirty years investment horizon. So you wanna have a mixture of both growth producing investments and also income producing investments as well. I think there's a danger of tilting too heavily towards income producing investments because then that can come at the cost of not sufficiently growing your portfolio over time.
Craig Rickman:Absolutely. And and as we know, growth continue for the money or your pension pot continuing to grow in retirement is a really important thing because it could span span decades. So, Yeah. Completely agree.
Kyle Caldwell:So the next question is related to inheritance tax and it came in following an episode in which we covered the upcoming changes to inheritance tax from the start of the next tax year in April 2027 in which, you know, for the first time, pension is gonna be caught by inheritance tax. So I'll read the question out in full. I've withheld the name as they've given some personal details here. However, I do think there's aspects of this question in which other listeners will relate to. So the question asks, I think it'd be helpful to discuss how inheritance tax can be mitigated for April 2027 for those where the family home is a considerable part of the estate.
Kyle Caldwell:For example, our joint estate is worth around 2,800,000, including a house worth 1,000,000. The rest is mostly in SIPs and ISAs. We also mentioned they've money in cash building societies. I can make use of gifting rules, but the estate could be liable for around £800,000 in inheritance tax. Trusts may be an option, but I don't understand the complexity of the different types, and my research so far seems to suggest it may not be worthy.
Kyle Caldwell:Now, Craig, you can't give specific personalized advice, but what what are the key pointers that you can get across for this answer?
Craig Rickman:Sure. I mean, this is this is another example. I mean, this could be another sort of a stand standalone podcast just purely because of the complexities within the inheritance tax system, which I'm sure many people have have found. So it's probably best to to break this down into to two bits. So, you know, how you can give away a home when you die and how you could potentially give away your home, your family home while you're alive.
Craig Rickman:So let's let's look at death first. So when when it comes to to passing on your estate, there are some tax free allowances that you can use, and it's only the amount or the value of the assets above these allowances that are chargeable to inheritance tax, is 40%. So one is called the nil rate ban, that's 325,000. Everyone gets that. But you can get an extra 175,000 if you own your own home and you pass it to direct descendants.
Craig Rickman:So children, grandchildren, stepchildren, that kind of thing. So what that means if you're a married couple, you could potentially give away a million pounds. So people may have heard this that you can give a you can give away a million pounds of your estate tax free. That's why. But there are some sort of there there is a, you know, important part of what's called the the residence meal rate ban, the 175,000 you can get for passing on a home, which is that for every £2 your estate exceeds 1,000,000, £1 of that allowance is withdrawn.
Craig Rickman:What that means is for a single person, once your estate's worth 2,350,000, or for a couple, a married couple, once it's worth 2,700,000, your residence nil rate band is is lost. So essentially means that as a married couple, you can only pass on the 650,000. This is particularly relevant for in for this question, for this individual because they say they've got pensions, and as you you said before, they're due to come into the inheritance tax net, fall into the inheritance tax net from April. And this is one of those really strange situations, unique situations where you could create these incredibly sort of painful tax rates of perhaps 80% or more on on any unspent pensions you have. And the reason for that is some people may have heard about this potential double taxation, and if you die after the age of 75 where whoever inherits the pension could pay inheritance tax and income tax, which could create tax rates of sort of somewhere between 50 I think it's 5267%.
Craig Rickman:But if you're then if if your pension is is, you know, causing you to to lose the residence, nil rate band as well, it could create, you know, 80% or more tax rates. So this is one of those situations where that could apply. So that's sort of looking at, you know, your your home on death. So what can you do with your home if if you're alive? So can you give it away to your children?
Craig Rickman:Yes, you can. And because it's your main residence, private residence, there's no capital gains tax to pay. So that so that doesn't apply. It's it's a bit more complicated than that as I'll as I'll explain. So if you do give the your home to your children, you would have to move out of the home.
Craig Rickman:So you'd have to give it outright. You could potentially continue living there, but you would have to pay them a market rent. And the reason for that is if you weren't to do that, then it's called what's called a gift with reservation of benefit, which essentially means you've given an asset away, but you've continued to enjoy it. So you the h m r or HMRC would say, well, you kind of you haven't given it away because you're still continuing to use it. So, you know, they're the they're the things to to sort of watch out for.
Craig Rickman:The other thing is that if you, you know, if you give away your home, then the seven year rule kicks in, so you have to survive seven years for it to move outside of your estate. And the other aspect is that you no longer own own the home, your children own it. So, you know, if they decided at any point, there might be perfect harmony within your relationship, but they've decided at any point that they wanted to tear you out, then they potentially could. So, again, like, you know, inheritance tax is so complicated and it's so personal that, you know, before you were to do anything around it, then it's really important to take professional advice from, you know, a financial adviser, solicitor, accountant, potentially all three. And because it's because it's such a a personal thing, and you're gonna wanna make sure that the things you do are gonna be right for you and your family.
Craig Rickman:But, you know, you know, and and also, you know, I won't I won't go too much into trust because they're another incredibly complicated area, solicitors can help you with those. But, you know, examples like that illustrate the complexities within the system and the importance of focusing on, you know, your individual individual circumstance and doing the right thing for you.
Kyle Caldwell:I completely agree, but I think also before you get financial advice, it's important to have done your own research and you go into it with your, you know, your eyes wide open. But, yeah, as you said, I mean, I mean, it's a very, very complicated area, and I do think people can definitely benefit from tax advice, particularly related to housing tax.
Craig Rickman:Absolutely. That's think that's the thing is is if you're if you're reading up about it, you can identify that you've that you've got a problem and potentially how big that problem might be. So then you know there's a pressing need to go and speak to someone about it. And I guess the the other tricky thing around this is that the tax rules change, inheritance tax rules change. We've seen thresholds have been frozen since the late two thousands or the the tax free threshold that we mentioned earlier.
Craig Rickman:You know, big changes to to pensions coming down the track. There have been changes to farms, to businesses that have been introduced this year to AIM shares. So the fact that the Gold Coast keep moving can make things a lot harder as well, but the other point is you've you've sort of got you've got to start from somewhere, and then I guess that's the point is to review what you're doing on a regular basis.
Kyle Caldwell:So we're gonna be moving on from inheritance tax to kids. Don't worry. I won't be talking about my own ones. Instead, I'm gonna be talking about the key investor information documents related to funds. So Jane got in touch, and she says, I've been looking at different investments.
Kyle Caldwell:One of my self imposed rules is that a fund should have a risk level given on a kid of four or below. I'm 66. I'm trying to avoid taking on too much risk. I've also been considering ETFs. But in my research, I've found that they tend to have a higher risk rating than a similar actively managed fund.
Kyle Caldwell:I'd like to understand why this is, and I wondered if it make an interesting subject for your podcast. Thought this was a great question and quite a challenging one as well. So I've done quite a bit of research into it, and I've made some notes. So in these documents, as Jay mentioned, they give a number to show the risk level of a fund, and they range from one to seven. And as you'd expect, one is the lowest risk and seven is the highest risk.
Kyle Caldwell:So I think they're useful in the sense that they can help you determine what, you know, when you're doing your research, what what type of funds fits into each category. So on the on the low risk scale, you'd expect something like a money market funds, which is a cash like type fund to score one. And then at the more extreme end, you'd expect something like a fund invested in Latin American shares to score seven. However, what I'd say is that you gotta remember is that these scores are based on the historic volatility of the funds, so it's backward looking. So there's no guarantees that a fund that scores free today will stay a free in the future.
Kyle Caldwell:It could move up to a four or a five, for example. And also, there's no guarantees that a a fund that scores five today will be more volatile than a lower scoring fund in the future. However, I do think it's a useful things to think about as part of your wider research, but as, you know, I go much further in your research. I've looked onto the bonnet and understand how does the fund invest, what's the approach it is taking, is it investing in a more adventurous manner, a more cautious manner, or somewhere in the middle? Consider the investment style of the funds.
Kyle Caldwell:Is it investing in value shares, for example, or growth shares? And consider the types of companies the fund is investing in. Is it investing in larger companies or smaller companies, which tend to be more volatile over shorter time periods? And also consider, is the full manager taking a concentrated approach in terms of owning small number of shares? Are they owning between 20 to 30 shares, for example, or are they owning lots more shares?
Kyle Caldwell:They're owning 60 shares or plus. Although some funds actually own 200 plus shares there, and they're a lot more diversified and potentially lower risk than a fund that's owning a much less smaller number of shares. And I've also looked at what percentage is the top 10 holdings in a fund. If it's 70% or more, that's a pretty punchy portfolio. They've taken quite a lot of concentration and stock specific bets, and and that and that and that can increase the risk of the funds.
Kyle Caldwell:And what I'd also do is I'd look up at a performance chart of the funds as I think as I think this is a very useful way to see whether the the whether the retains have been relatively smooth, say, over five year period years or whether there've been quite a lot of bumps in the rows. So, yeah, I think these risk scores on on the kid documents, I think they're they're useful, but I wouldn't use them purely in isolation. And and some further to add to that, Craig?
Craig Rickman:Only something short. I think that, you know, in some cases, you can deviate away from, you know, your kind of sort of standard attitude to risk. So you might think that you're, you know, for example, a risk level four, but you you there's no there's no reason why you can't take perhaps a bit more risk with some elements of your portfolio because it's it's the it's the overall attitude to risk that that that matters. It's the overall risk within your portfolio. So you could invest in things that are a bit that a bit riskier that could potentially generate some higher returns.
Craig Rickman:But if it's a small part of your portfolio, then and you've got other assets that are sort of supporting it, then that can still be an option as well. So you don't necessarily just have to limit yourself to a, you know, a maximum risk score for funds with, you know, across your across your whole portfolio.
Kyle Caldwell:And to address the point that Jay made about in her research, saw some examples of ETFs having a higher score than a similar actively managed fund. Again, I think it's important to look onto the bonnet and take each one in turn. Consider how is the ETF investing. Is it is it offering plain vanilla exposure to track and say the Footsie Oil Shared or the S and P five hundred, or is it doing something slightly different? Is it investing in a particular theme or sector or part of the market?
Kyle Caldwell:There are some ETFs that will only invest in high yield and dividend shares, for example, and also take a look at how concentrated the ETF is. There are some instances in which I've seen, you know, some examples of ETFs having nearly half their portfolio in just a handful of stocks, and that is a higher risk, more concentrated approach than, you know, an ETF that has lower percentage weightings and has a wider spread of companies. But I also do think just to finish off the actively for active managers, they have greater scope and opportunity to invest sufficiently differently from the wider market. And when we have these risk off periods for markets, they have greater opportunity to own more defensive shares. They can raise cash.
Kyle Caldwell:Whereas if you're just investing in the market, then the market will will fall, and you'll get the the retain during that periods of however it performs. Whereas an active full manager in those scenarios and indeed over the long term, they have the ability to try and add greater value beyond the returns that you can get from an index or an ETF. Of course, there's no guarantees, and, you know, the data does indeed show the you know, if you if you're looking at averages, the average for manager doesn't beat the average index fund, and that's across various different regions. But there are some that do outperform, so it's really important to go away and do your own research and homework to try and find them. So Craig, that's it for our question and answer episodes.
Kyle Caldwell:Thanks for joining me.
Craig Rickman:Thank you very much for having me.
Kyle Caldwell:And that's all we have time for today. I'd love to hear from more listeners. So if you have a question that you would like us to tackle in a future episode, then do get in touch by emailing otm@ii.co.uk. I also welcome thoughts on the podcast and ideas for future topics or themes that you would like one of us to cover. In the meantime, you can find plenty of practical pointers related to personal finance, funds, investment trusts, and ETFs on the Interactive Investor website, which is ii.co.uk.
Kyle Caldwell:And, hopefully, I'll see it again next Thursday.