Sale of Capital to Provide Income - Update

In early 2015, 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. 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’.

My Vanguard FTSE Equity Income pays 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 4.5%, the natural yield on the VLS fund is currently only around 1.3%. The plan was therefore to sell off some units from the accumulation version of my fund to provide ‘income’.

It would not be viable to sell units on a monthly or quarterly basis due to the dealing costs involved - currently £12.50 per sale transaction with my Halifax Share Deal ISA. I therefore plan to sell down capital units from VLS just once per year.

There is also the question of 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 5 years. The average total return for the VLS 60 fund since launch has been 8.2% p.a. so at first glance you would think it would not be a problem to sell down 4% of units each year to use as income.

However, whilst the past 5 years have been reasonably positive for both equities and bonds, I am expecting the longer term average to come down to nearer 6% p.a.

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

To June 2012  3.36%

To June 2013 12.05%

To June 2014   7.98%

To June 2015   7.28%, and

To June 2016 10.55%

Total return for the current year-to-date is 12% - much of this is due to a recent surge and the result of the falling value of sterling post the Brexit result.

I have been viewing Vanguards simulated asset class risk tool for the 31 yr period 1984 to 2015 and using a 60/40 equity/bond allocation. Over this longer period the average return has been 9.5%. There have been just 5 years when returns were negative and 26 yrs when returns have been positive.

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 have therefore put in place a cash buffer - an instant access building society account - which holds the  income I would require for at least three years - so a minimum of 10% of the VLS fund value. This should provide a sufficient buffer and enable me to draw 3.5% income for 3 yrs without selling any units in my index fund.

During the positive years I will rebuild any shortfall in the buffer account to bring it back to the 10% 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 say 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.

My First Full Year

Fortunately, the returns from my VLS fund has been positive. Last month the return was just 4% but after the recent fall in sterling - currently $1.30, the value of the fund has increased by 15% over the past year.

Of course, this inflated value will fall back should the GBP rally against the US dollar. In view of the unexpected windfall, I have this week sold 8% of my units - sufficient for 2 years income. The additional 4% will be added to my cash buffer which now stands at 14.15% including the accumulated interest over the past 12 months.

The VLS 60 fund currently stands at an all time high of £155.  Back as recently as February, the fund was in negative territory at just £131 and at this point I was thinking I would need to use my cash buffer in my first year. Just goes to show how fickle the markets can be and how quickly and dramatically things can turn from negative to positive - just like life I guess!

For most of my investing career I have taken the natural yield from my shares and investment trusts - and for income seekers this can be a very good strategy. However it can create blindspots as you tend to filter options according to yield which obviously would rule out the likes of Vanguard Lifestrategy funds and many other perfectly sound investment opportunities.

I imagine most investors would make use of the LifeStrategy funds during the build stage of their investing career - usually via monthly DD on auto with their broker but I hope this will demonstrate it can also be an option during later years when the emphasis may shift towards preservation of capital and generating income.

So far,so good.