Could your ISA become a cash cow?

Where will your income come from in retirement? For many people, the answer is likely to be not simply from dedicated pension savings, whether with the state or in private or workplace plans.

There are good reasons to look beyond pensions. For example, you may need income to supplement earnings from part-time work in retirement, particularly if you opt to delay taking your pension.

Moreover, tax-efficiency is available elsewhere and other savings vehicles offer greater flexibility; and, unlike pension funds, they won't leave you vulnerable to the vagaries of the annuity market when you need to draw an income.

Retirement sense

Holding savings earmarked for retirement in an individual savings account makes sense. The long-term nature of retirement saving means the protection ISAs offer from capital gains tax is more likely to prove valuable. And when you come to draw an income from your savings, there is no further tax to pay on the yield generated by assets within an ISA.

Still, one advantage of a dedicated pension product is that it is structured specifically with retirement in mind - it builds as large a fund as possible while you're saving and then pays a guaranteed income for as long as you need it in old age.

Investors who choose to provide for retirement using ISAs - entirely or partially - must manually structure their portfolios in a way that achieves the same ends.

I would typically recommend an ISA portfolio based around high-yielding UK equities, investment-grade corporate bonds and UK commercial property."Martin Bamford

"There are two primary conditions to meet, in order to make an ISA a useful investment for retirement income," says Jaskarn Pawar, a chartered financial planner at Investor Profile.

"The first is to make sure the income generated is sufficient for your needs - every investor I know focuses on this very well. The second is to ensure the income is sustainable, and this area is always a weakness for investors because they focus too much on the yield."

To put that more bluntly, there's no point in achieving the income you need from your ISAs for the first five years of retirement if you then run out of cash.

Rather, investors need a portfolio structure that preserves capital and provides the income they had hoped for. In fact, they actually need more than that. Inflation erodes the purchasing power of incomes, so a rising income is necessary to keep pace with increases in the cost of living.

How, then, to balance the need for an inflation-proof income with the importance of capital preservation?

The first point to make is that the income you withdraw from your ISAs doesn't have to be income in the strictest sense of the word. And since ISAs aren't especially income tax efficient - there is no facility to reclaim the 10% tax deducted from dividends at source - there's no point focusing exclusively on investments that are designed to be income-oriented.

"It makes more sense to adopt an appropriate total return strategy," says Alistair Cunningham, financial planning director at Wingate Financial Planning.

"If a retiree needs, say, 3% above inflation, and the portfolio is generating a greater total return than this, it doesn't matter whether their income comes from crystallising capital gains by selling investment units, or from dividends or interest."

Exposure

Still, investors depending on investment income in retirement can't afford to take excessive risk. While stockmarket exposure may be your best hope for generating the returns necessary to pay an appreciating income in future - whether from rising dividends or capital appreciation - you will probably also want less adventurous assets to produce income in the here and now.

One option, says Kusal Ariyawansa, a chartered financial planner at adviser Appleton Gerrard, is to build your portfolio on the basis of time horizons.

"Consider breaking up the portfolio into chunks that address your short, medium and long-term income needs," he suggests. "Decide on how much income you will need over the short term - less than five years, say - and invest the right portion in fixed-interest funds to generate this; take a longer-term view with the rest, increasing risk by investing in equity funds in line with the annual growth rate you require to maintain this income after taking inflation and charges into account."

That strategy has to be reviewed regularly over time, with the gains earned on the longer-term holdings recycled into the short-term pot as investors get older. The idea is that the equities element of the portfolio should achieve average annual returns that are at least sufficient both to fund new investments in fixed-income assets and to replenish the long-term portion.

A wide range of assets might be suitable for these needs. Ariyawansa currently favours short-dated bond funds such as Brown Shipley Sterling Bond and Dimensional Global Short Dated Bond for short-term income generation, but there are plenty of other options. Assets such as property and infrastructure funds, for example, may offer useful diversification as well as market-beating yields.

Portfolio approach

These primary generators of income must then be balanced against the assets designed to produce growth, says Martin Bamford, managing director of Informed Choice Chartered Financial Planners.

"I would typically recommend an ISA portfolio based around high-yielding UK equities, investment-grade corporate bonds and UK commercial property," Bamford says.

"But the larger your ISA portfolio, the more diversification you should consider across both asset classes and funds - adding global equity income, high-yield corporate bond and infrastructure funds could reduce the overall risk of a larger ISA portfolio and potentially boost the income yield further still."

The larger your ISA portfolio, the more diversification you should consider across both asset classes and funds to reduce the overall risk of a larger ISA portfolio and potentially boost the income yield further."Martin Bamford

He thinks a yield as high as 6% is sustainable in current market conditions.

However, these diversified portfolio structures do presuppose that investors have a sufficiently large savings pot to make it economic to hold such a wide range of funds.

If not, an alternative approach is to look for a single vehicle that aims to do the same job as the portfolio approach, with a diversified portfolio of assets designed to deliver consistent returns and a steady income.

A fund such as Axa Distribution, which splits its holdings between UK equities and gilts and aims to deliver a growing income, is one possibility.

Finally, savers in retirement shouldn't forget that most assets within an ISA are still subject to inheritance tax - that is a potential headache for those with an estate above the threshold (£325,000 in the current tax year or £650,000 for a married couple).

Alternatively, most stocks listed on the Alternative Investment Market (AIM) escape the inheritance tax net after investors have held them for at least two years.

Since last August, AIM shares have been permissible ISA holdings.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.