Kyle Caldwell comes up with some investment suggestions for Isa portfolios that could deliver £10,000 in income.
Nearly two years on from the introduction of radical pension freedoms, one of the key trends to emerge from official pensions data is that savers are drawing on their pension pots more frequently.
At first glance, this is a worrying sign that raises fears that the baby boomer generation might rapidly blow its pensions - a concern widely aired before the freedoms were introduced.
This, thankfully, is not the case, as the statistics also show that those taking advantage of the freedoms are taking out limited amounts per withdrawal.
On the whole, this adds to the general feeling that the vast majority of pensioners are being prudent, rather than reckless, with some choosing, in effect, to pay themselves an income in retirement by running their own pension portfolios.
DIFFERENT RISK LEVELS
In the current investment climate, however, achieving a decent income is easier said than done, especially with the once common basic split between blue-chip equities and government bonds no longer cutting the mustard as far as a respectable yield is concerned.
Once again, we have accepted the challenge of trying to deliver a £10,000 income from portfolios positioned at three different risk levels - adventurous, middle of the road and cautious - and calculating the amount of capital needed in each case to achieve that income goal.
Each portfolio has been put together using Money Observer Rated Funds, with the asset allocation weightings decided in conjunction with financial advisers.
One of our six-strong income-oriented Model Portfolios, or indeed a combination, may also fit the bill.
A yield of 5 per cent was the rather ambitious aim for the adventurous hypothetical portfolio - the punchiest of all. Patrick Connolly, a financial planner at Chase de Vere, notes that investors need to have a stomach for risk.
He says: 'The days of generating an income of more than 5 per cent a year without taking too much risk now seem long gone, so income investors are having to make difficult decisions in terms of the level of income they want or need, and the amount of risk they're prepared to take to get it.'
To achieve a yield of 5 per cent, which would pay £10,000 of income on an initial investment of £200,000, less secure fixed-interest assets such as high-yield and emerging market debt need to be considered.
The Royal London Sterling Extra High Yield Bond has been chosen for the adventurous portfolio, because of its meaty yield of 7.2 per cent and the fact that manager Eric Holt aims to provide investors with a high level of income without taking the risk normally associated with high-yield funds.
Holt focuses on security by favouring bonds secured against specific assets in areas where valuations are attractive.
In the adventurous portfolio, 75 per cent has been allocated to equities, split between various geographical regions. The portfolios are light, however, when it comes to the US and Japan.
Because of the low fund yields on offer for the two countries, around 2.5 per cent and 2 per cent respectively, other regions take precedence.
The global fund picked, Artemis Global Income, is light in terms of exposure to both regions. Other global funds will have higher weightings, giving investors the option to boost exposure if they see fit.
Adrian Lowcock, an investment director at Architas, says: 'Targeting 5 per cent is difficult and requires compromises. The main problem is that some sectors, such as commodities, are not traditional income assets and don't feature in high-income portfolios.
'Funds focused more on wealth preservation, which are set up to keep their heads above water when markets fall, are also hard to find room for when aiming for a high level of income.'
Another compromise to be made is the sacrifice of some capital growth in exchange for income by opting for one of half a dozen or so 'income maximiser' or 'income booster' funds.
These specialist funds sell derivatives to boost income; they have been designed for investors who want immediate income.
Schroder Income Maximiser was chosen for this portfolio, at a 20 per cent weighting, to help lift the overall portfolio up to the 5 per cent yield mark.
According to financial planners, the 20 per cent figure is 'at the high end' in terms of the amount someone who wants or needs to generate a high income should be investing in such funds.
Capital growth is therefore sacrificed, so when stock markets are riding high, don't expect these funds to keep up. Equally, in extreme periods when stock market volatility reigns, these funds are never going to top the capital preservation league table.
The big predicament facing income investors is that in a normal scenario, equities are considered a much riskier bet than government bonds. The trouble is that we are in uncharted territory.
Rob Morgan, a pension and investment analyst at Charles Stanley Direct, says: 'All the textbooks say bonds are generally low risk, but this no longer applies, because bonds are expensive on valuation grounds, much more so than equities.'
The consensus among various analysts is that yields will continue to gradually rise over time, as the reflation trade borne out of fiscal policy continues to play out.
Care therefore needs to be taken when upping the bond allocation, to ensure the balanced portfolio does not end up becoming inadvertently riskier than an adventurous portfolio.
With this in mind, a flexible bond fund has been added to the mix: Jupiter Strategic Bond.
Manager Ariel Bezalel has the freedom to invest in any type of bond and move the portfolio around in response to the changing economic environment.
Bezalel is in cautious mode, having recently reduced the fund's overall credit risk in light of the expected rise in inflation.
By upping the initial capital investment to £225,000 and reducing the yield target to 4.5 per cent, £10,000 of income can be generated, despite an allocation of just 5 per cent to Schroder Income Maximiser.
As the yield target falls (and the starting capital requirement rises), investors have a wider fund choice. Greater diversification can then be achieved and risk reduced.
Another commonality is that both funds have specialist income booster funds among their top holdings in order to boost their own fund yield. Indeed, both favour Fidelity Enhanced Income, yielding 6.6 per cent, as their largest position.
The highest yielder in the cautious portfolio is another fund in the strategic bond sector, Invesco Perpetual Monthly Income Plus. Unlike other funds in the sector, this has an element of equity investment, up to a maximum of 20 per cent, which gives it extra flexibility.
With just 30 per cent in pure equity funds and no exposure to maximiser or booster income funds, £10,000 is achieved on a £250,000 investment.
SOME TAKE THE TRACKER ROUTE
For those who favour passive funds, the £10,000 target can be achieved by mimicking the asset allocation weightings of each hypothetical actively managed portfolio.
When building the portfolio, it is a case of seeking out the cheapest index funds or exchange-traded funds that also boast low tracking errors (a volatility measure that assesses how consistently a tracker fund has replicated the index over a certain period).
Booster funds are not an option when an investor goes down the passive route. Instead, various 'smart beta' funds can be deployed that screen for companies meeting certain criteria, rather than by market capitalisation.
One strategy is to construct an index weighted towards the highest-yielding companies. The passive options here include the iShares UK Dividend Ucits ETF, which invests in the 50 highest-yielding companies in the FTSE 350 index and yields 4.9 per cent.
Alternative options outside the UK have much lower yields. For example, the Vanguard FTSE All-World High Dividend Yield Ucits ETF, which targets global shares with above-average yields, has a yield just shy of 3 per cent, as does the S&P Euro Dividend Aristocrats UCITS ETF.
Passive investors will probably need a higher initial investment than those taking the same path as the three active hypothetical portfolios. A higher allocation to high-yield bond ETFs may also be required, which will increase risk.
HOW MONTHLY INCOME FUNDS WORK
A couple of dozen funds pay income monthly, and some have been included in the three hypothetical portfolios.
The fund managers invest in shares, bonds or a mixture of the two. The amount of income generated is based on the dividends the underlying holdings have paid each month.
Therefore, as with any fund, the income can vary. But to counteract this variability, most of the funds smooth the dividend payments into 12 equal amounts, holding back some income in good months and using it to top up dividends in leaner periods.
Any excess cash lefiover at the end of the year is then handed back to investors. Fund managers are therefore not constrained in needing to be tactical around the dates dividends are paid throughout the year.
HOW OUR 2016 PICKS FOR A £10,000 INCOME FARED
Both our two 2016 Rated Fund portfolios, which comprised open-ended funds and investment trusts, fell short of their income targets last year.
Our medium-risk and higher-risk portfolios (March 2016) generated income returns of £9,340 and £8,700 respectively.
The income figures were calculated using the '12-month yield figure' supplied by Morningstar.
This represents the sum of a fund's total trailing 12-month interest and dividend payments divided by the last month's ending share price plus any capital gains distributed over the same period.
In terms of capital returns, however, it was a strong year, with the medium-risk portfolio turning an initial investment of £260,000 into £283,800, while the higher-risk portfolio turned £210,000 into £233,760.
The main reason why both portfolios underperformed in terms of income generation is a positive one: equity markets have on the whole enjoyed a strong run over the past 12 months.
Rising share prices mean global equity income funds in particular have seen bumper overall returns.
For example, Artemis Global Income, which won a place in both our 2016 portfolios, posted a gain of 28.4 per cent, while Invesco Perpetual Select Global Equity Income, a constituent in the medium risk portfolio, was up 28.9 per cent.
But as fund prices have risen, yields have fallen. Last year, for example, Artemis Global Income had a yield of 3.9 per cent, but the 12-month yield figure today stands at 2.8 per cent.
In effect, when markets are rising generally, investors should not worry if the target yield is not achieved, as they can always top up the shortfall with capital in good years.