Monday 10 August 2015

Selling Capital Units to Provide 'Income'

A few years back, I retired from full time paid work. I have managed to build a modest pension pot in my SIPP and also hold various investments in my S&S ISA (previously PEP) gradually accumulated over the past 20 yrs or so. I calculated that I could just about live off my savings, sipp pension and investment income, knowing my state pension would be available from age 65 yrs.

The original strategy was to hold a mix of income generating shares, investment trusts and fixed income securities. I would draw down the natural income from these investments leaving the capital untouched. Over the past 7 years, the plan has been working out much as planned.

As around 60% of the portfolio is invested in equities, the income and dividends would hopefully increase year-on-year to provide a hedge against inflation.

So far, so good.

Revised Strategy

Earlier this year, I began the process of reviewing my investment strategy and concluded that I would make a shift away from individual shares and some managed investment trusts in favour of more index funds and ETFs. I was particularly drawn to the simplicity and balance of the Vanguard LifeStrategy option. This one-stop solution formed the central theme to my latest book ‘DIY Simple Investing’.

Some of my index funds such as Vanguard FTSE UK Equity Income, pay a reasonable income however I do not want too much exposure to the UK equity market, therefore an increasing proportion of my portfolio has been reinvested in the VLS funds which are globally diversified.

However, whereas the yield on my UK Equity Income fund is around 4%, the natural yield on the VLS fund is currently only around 1.3%. I anticipate that I will probably need to sell some of the capital each year to make up the shortfall so I have purchased the accumulation version of the fund.

I will need to take account of platform costs and fund charges which together will be ~0.30% so my actual amount withdrawn will probably be nearer to 3.7%.

It would not be viable to sell units on a monthly or quarterly basis due to the dealing costs involved - currently £12.50 per transaction with my Halifax Share Deal ISA. I therefore plan to sell down capital units from VLS just once per year. The question now to be addressed is what to do about the years when there is little or no capital growth to cover the 4% sell down or even years when there is a reduction in the capital value.

The Plan for Selling Capital

The LifeStrategy funds have been going for just over 4 years. The average total return for the VLS 60 fund since launch has been 8% p.a. so at first glance it would be easy to think it would be possible to sell down 4% of units each year to use as income.

However, the past 4 years have been reasonably positive for both equities and bonds and I am expecting the longer term average to come down to nearer 6% p.a.

Also the 8% is averaged out over the four years. Looking at each year separately, the rolling 12m returns have been:

To July 2012  3.36%

To July 2013 12.05%

To July 2014   7.98%, and

To July 2015   7.28%

Total return for the current 7m year-to-date is 2.98%

I have been viewing Vanguard's simulated asset class risk tool for the 30 yr period 1984 to 2014 and using a 60/40 equity:bond allocation. Over this longer period the average return has been 10.2%.

There have been just 5 years when returns were negative and 26 yrs when returns have been positive.

The worst single year was unsurprisingly 2008 with a loss of 18% and 3 consecutive yrs, 2000, 2001 & 2002 when total returns were zero or negative.

The plan will therefore need to be flexible enough  to avoid needing to sell capital when total return for the year is flat or negative.

I will therefore maintain a cash buffer - an instant access building society account - which always holds at least the equivalent of the income I would require for at least two years - so a minimum of 8% of the VLS fund value. This should provide a sufficient buffer and enable me to draw 4% income for 2 yrs without selling units in my index fund.

During the positive years I will rebuild any shortfall in the buffer account to bring it back to the 8% min. and when this is restored I will simply sell 4% of the value of my VLS fund for income. Obviously, should there be a run of consecutive returns above 4% or 5%, I will have the option to build up the buffer account to a higher percentage, take more ‘income’ or leave the excess returns invested within the VLS fund.

I have made a note to look at the return figures at the first anniversary of my initial purchase next June.

If any readers can suggest a better way to operate this or they already use their own system, please feel free to leave a comment below.


  1. Very interesting article John. I don't have any suggestions beyond your buffer, as that's more or less the plan I intend to use at some point.

    1. John,

      The cash buffer was the only way I could think would address the shortfall during the inevitable periods of falling markets. Good to hear you would probably do the same!

    2. I don't know why you don't just cancel 4% of units in bad as well as bad years. It may psychologically feel better but the opportunity cost of having an 8% cash buffer is surely more damaging to portfolio growth over the long-term. Also while I can see at £12.50 a trade you don't want to be selling every week 4 quarterly trades of 1% of portfolio a year doesn't feel excessive (And I am an obsessive 'keep costs down' investor).

      Finally and separately platform costs of 0.3% are quite high and I wonder if you have thought about moving? Depending on the size of your portfolio a flat rate broker may offer better value.

    3. Adrian,

      I am not sure I could bring myself to sell 4% of my holding when it has, eg just reduced by 10% over the past year and not knowing whether the coming year would see that reversed or maybe another poor year. I think for peace of mind I need to fall back on a cash buffer.

      I should make clear the ~0.3% costs includes the OCF for the fund of 0.24%.

  2. Interesting post, John.

    The sale of capital in order to cover expenses is, obviously, a bit of a pain. I think your buffer policy is a very good idea especially at 2 years. That should allow you to ride out the worst excesses of the market.

    Another alternative may be to transfer to a broker which does not charge a flat broker fee but a platform charge instead. Usually that would mean you could sell down in installments much easier. However, a buffer would still be needed!

    Just a thought!

    1. DD,

      I am not sure about the idea of moving from a flat fee broker would help. I know the likes of Charles Stanley Direct would not make a charge for the sale of units so it would be economical to sell down smaller amounts on a regular basis. However, there would be the 0.25% platform fee - say my VLS holding was £30,000, this would be £75 pa (0.25%) whereas I currently pay a platform fee of £12.50 pa + £12.50 (0.08%) for an annual sale of units.

  3. Interesting post, especially as I am in a similar situation. I have been moving my investments across to ETFs and low cost funds and have noticed the same - Original funds were producing 4%+ and the ETFs and low cost funds are only returning 1-2% so the income has reduced. To maintain a 4% income I would also need to hold a mix of growth funds and sell capital periodically to balance.

    The brokers are currently all changing their charging structures so there could be one out there that suits your needs and enables you to sell capital periodically without charges taking a bigger slice of the proceeds than necessary.

    I have a cash pot which covers 2 years expenses for any poor years - can't think of any other option to spread the risk.

    1. Good to hear from you SB.

      I suppose if you are not living off investments its not such an issue - go for acc funds where yield is immaterial or reinvest income distributions from ETFs or investment trusts. All other things being equal such as charges etc. the end result should be the same.

      When it eventually comes around to living off the investments, I need some plan that I can be reasonably confident the income required will flow on a sustainable basis.

      When the state pension kicks in, this will be less of an issue as that will cover the basics and the investments and pension income will be additional. Lets see how it goes for the next 3/4 yrs!

      Thanks for stopping by and good luck with your own blog.

  4. Have you had a look through the VPW method espoused by some of the Bogleheads? Makes interesting reading ...

    1. Thanks very much for the link MD, I will certainly follow it up and have a read.

  5. Hi,

    Interesting reading :). Any reason you choose 2 years to hold in cash? Rather than say 1 or 5?

    Mr Z

    1. Mr Z,

      Thanks for stopping by. Good question..I was looking at the run of down years over the past 30 yrs and as the most is 3 and more often just 1, then I am hoping 2 years worth of reserves should cover most situation.

      Also, the VLS fund only represents around 10% of my portfolio so even in the 'down' yrs, there will still be dividends and income coming in from the rest of the portfolio. If it represented a large percentage of the whole, there may well be a case for having a bigger buffer.

    2. Ah I see, makes sense :) One of these things that needs to be an informed decision and makes you feel comfortable? So hard to quantify!

      I was thinking 5 years in bonds and cash as I remember having a look a while back and thinking that would hopefully be enough time for equity to recover following a down turn.


      Mr Z

    3. I think with the VLS60 which is always 40% bonds, you would almost certainly not need a 5 yr buffer - maybe if you are 100% equities this may be more appropriate.

      I will probably go with the 2 yrs and see how it pans out - it should be an interesting process.

  6. very interesting. just what id been pondering in drawdown for myself
    2 year cash buffer. your research is helpful
    another school of thought for me is to delay taking state pension for 5 years then it goes up to £12,000 pa which is my ideal income [what I live off now] then from 60 ,finish work ,live off portfolio and buffer only for 12 years !!! then when state pension kicks in, whats left of portfolio would be nice but not acutely necessary extra. I envisage living into my 90,s so if portfolio gets ravaged in those 12 years its not end of world.

    1. aurora,

      Thanks for your thoughts. The benefits for delaying the start of my state pension are not going to be as generous or tempting as they currently are. I do not therefore propose to delay after age 65.

      I do feel fortunate to still be able to get it at 65 - some not much younger will be waiting to 67 and I suspect before too much longer it will be 70. As you say, if the state pension can cover your day to day living costs, the extra from your investments will provide the extras but not essential - ideal.

  7. another thought....
    I was also considering a once year withdrawel to keep dealing costs down. When would you do this?
    They say most stock market gains are between the months of Oct and May, so would May be the ideal month? any thoughts on the time?

    1. As June 2016 will be the first anniversary from initial purchase, I thought this may be the most appropriate time.

  8. Hi DIY

    I have been thinking about the problem of drawing down capital myself. I will need to fill the gap between finishing work (when I am 58), and receiving a final salary pension (when I am 60) and also my state pension (when I am 66). Once I am receiving both of these I should be in a position where I am receiving more income from the portfolio that (hopefully) remains.

    I have come to a similar conclusion as yourself i.e a cash buffer, topped back up each year, but this will need me to move from individual shares to funds, so I will need to research both the best value broker for such a strategy and the best funds in order to maximise my income.

    I look forward to following your progress as you are a few years ahead of me.

    Best Wishes
    FI UK

    1. FI,

      I get the impression that you are reasonably comfortable holding a diverse portfolio of shares. Could you not just continue with these and syphon off the natural dividend income?

      I guess you have some time to evaluate which method will work out the best for you.

      I have recently sold a further tranch of my shares - easyJet, GSK and Booker and will shortly be reinvesting the proceeds into my LifeStrategy fund with Halifax ISA.

      Good luck with your progress toward early retirement - as always, I enjoy your regular posts.