Here at Monevator, a frequent request is for a post on leveraging the low costs and in-built diversification of ETFs in order to generate an income in retirement.

And as the resident Monevator writer on all things retirement, it falls to me to respond.

In my previous article I explained why I thought that ETFs weren’t necessarily the proverbial answer to a maiden’s prayer when it came to generating an income in retirement.

In particular, I highlighted the lower yields from traditional total market ETFs, and the travails of the iShares’ FTSE UK Dividend Plus ETF (IUKD). To get the most out of this article, read that article first.

But I also undertook to present two example ETF portfolios.

The first portfolio would be drawn from the very biggest ETF providers. It would boast very low charges. It would aim to deliver a globally-diversified passive income, from equities and fixed income investments, of the same sort you’d expect to get from an alternative strategy such as a global investment trust or fund.

The second portfolio would shop for so-called ‘smart’ income-seeking ETFs – again with a global dimension – and deliberately aim for a diversified spread of ETFs and ETF providers. The strategy – through an element of diversification – would try to minimise the downsides of ETF algorithms blowing up, à la IUKD.

It’s a small world

In this article I’m going to focus on the first of these case studies, the passive market cap index tracking income portfolio. As a bonus, I’ve created not just one portfolio, but two.

That is, two takes on the same thing, but from two different providers. The two 800lb gorillas of the ETF world, in fact: iShares (once owned by Barclays, now part of BlackRock), and Vanguard.

Between them, these behemoths control 55% of the global ETF market. They have used their scale to drive down ETF costs.

One consequence is that while iShares and Vanguard are recording year-on-year net inflows into their funds, customers are deserting the smaller (and usually more expensive) players such as HSBC, Deutsche Bank, Lyxor, UBS, and Amundi.

Both Vanguard and iShares again cut some of their fees in December – in iShares’ case following hefty cuts to its so-called ‘Core’ range of low-cost ETFs in October. Each cut strengthens the theoretical appeal of ETFs to investors wanting a retirement income, by increasing the cost gulf between the actively-managed investment trusts I tend to favour, and passive ETFs.

There’s no reason why a private investor would need or want all their ETFs to come from one fund house, as I’ve done here. Indeed, it might even be considered a small notch up on the risk-o-meter, in that you’d have all your eggs in one basket in the very unlikely occurrence of one of these giants failing.

I’m doing it for comparative purposes. You can roll your own portfolios to suit.

A retirement income using Vanguard ETFs

Let’s start by building a passive portfolio using ETFs from Vanguard.

Owned by its customers rather than a third-party bank or other financial institution, Vanguard has – appropriately enough – been in the vanguard of the push to drive ETF costs down.

I’ve selected six low-cost vanilla ETFs, with a two-thirds equity and one-third fixed income split, as follows:

Ticker	ETF	OCF	Yield
VUKE	FTSE 100 UCITS ETF	0.09%	3.83%
VERX	FTSE Developed Europe ex UK UCITS ETF	0.12%	2.81%
VAPX	FTSE Developed Asia Pacific ex Japan UCITS ETF	0.22%	2.83%
VUSA	S&P 500 UCITS ETF	0.07%	1.67%
VGOV	U.K. Gilt UCITS ETF	0.12%	1.60%
VECP	EUR Corporate Bond UCITS ETF	0.12%	0.38%

Source: Author’s search of provider data.

Clearly, one can play tunes with this.

• As presented, Japan is missing. Vanguard does not yet appear to have an ETF embracing all of developed Asia Pacific including Japan, so investors wanting exposure to Japan could add Vanguard’s FTSE Japan UCITS ETF.

• Emerging markets exposure? That would be Vanguard’s FTSE Emerging Markets UCITS ETF (VFEM, on an OCF of 0.25%).

• The inclusion of Vanguard’s European-focused EUR Corporate Bond UCITS ETF? Simply because Vanguard presently has no UK-only (or even UK-mainly) corporate bond ETF offering.

Readers might also wonder why individual regional ETFs have been chosen, rather than Vanguard’s all-in-one solution, the company’s FTSE Developed World UCITS ETF. (This is denominated in dollars under the ticker VDEV, on a yield of 1.97%, and in pounds on a ticker of VEVE.)

The answer: cost. With an OCF of 0.18%, it’s a pricier option than Vanguard’s FTSE 100 UCITS ETF (0.09% OCF), FTSE Developed Europe ex UK UCITS ETF (0.12% OCF), and S&P 500 UCITS ETF (0.07%) products.

Remember that as with any other unhedged investments you make overseas, you face currency risk with foreign market tracking ETFs.

Currency risk simply describes how the fluctuating level of the pound versus other currencies will in turn cause both income and capital values to vary. This occurs irrespective of what currency your fund is denominated in (and to be clear it’s a factor with most investment trusts and other funds, too).

• Learn about currency risk and ETFs, trackers, and other funds.

• Read up on currency hedged ETFs.

In general, the ETFs cited in this article and most commonly offered to UK investors are Irish-domiciled1 rather than hailing from the United States.

Irish-domiciled will be most familiar to UK-based investors, but readers should note that there are circumstances where (according to what I’ve read—I’m no tax specialist) United States-domiciled ETFs are subject to a lower overall tax take.

A retirement income using iShares ETFs

Now, let’s now look at building a similar portfolio using ETFs from iShares. Here’s a similar table to the Vanguard table, in identical order, following the same logic of a regional equity focus, and a one-third allocation to fixed income.

Ticker	ETF	OCF	Yield
ISF	iShares Core FTSE 100 UCITS ETF	0.07%	3.86%
EUE	iShares EURO STOXX 50 UCITS ETF	0.35%	3.36%
IPXJ	iShares MSCI Pacific ex‑Japan UCITS ETF	0.60%	3.19%
IUSA	iShares S&P 500 UCITS ETF	0.40%	1.35%
IGLT	iShares Core UK Gilts UCITS ETF	0.20%	1.85%
SLXX	iShares Core £ Corporate Bond UCITS ETF	0.20%	2.91%

Source: Author’s search of provider data.

As with the Vanguard portfolio, there are a few points to note, in addition to the broad principles laid out above.

Chief among these is that iShares’ touted low costs aren’t necessarily all that much use to income investors wanting an easy life, especially when ill or inform in old age. That’s because some of iShares’ lowest-cost ETF products—from its ‘Core’ range—aren’t available on an income-paying basis.

Instead, with the low-cost ‘Core’ range, the income is often (but not always) rolled up into the price – effectively turning them into what the investment fund world calls accumulation units, rather than income units.

iShares’ attractive-looking Core S&P 500 tracker, for instance, is available with an eye-catching OCF of just 0.07%, but if you want an actual income, you’ll have to either periodically sell some of your capital, or buy an iShares ETF under a different ticker that does offer income – in this case, iShares’ IUSA iShares S&P 500 UCITS ETF (not iShares Core S&P 500 UCITS ETF), which comes with a much heftier OCF of 0.40%.

So, in each case above – bearing in mind that this is an article focusing on an ETF-derived natural income in retirement – I’ve listed ETFs that actually do pay out an income.

Diehard ETF proponents of passive investing, of the persuasion that regularly appear in the comment sections on these articles, may not see periodic selling of ETF capital (at the market’s lows, as well as its highs, as required) in order to generate an income to be a problem.

Each to their own, but that strategy is obviously outside the scope of this article – and would render the table above incompatible with the Vanguard one I listed earlier for comparison purposes.

That said, should investors be interested in the ‘sell to create an income’ strategy, here are the ETFs in question:

Ticker	ETF	OCF
CSSX	iShares Core EURO STOXX 50 UCITS ETF	0.10%
CPXJ	iShares Core MSCI Pacific ex‑Japan UCITS ETF	0.20%
CSPX	iShares Core S&P UCITS ETF	0.07%

Source: Author’s search of provider data.

Passive ETFs in retirement: the bottom line

So what conclusions can we draw from this discussion?

To my mind, there are four:

• The income to be expected from such a portfolio of passive ETFs is lower than that offered by leading income-centric investment trusts – but so too are the fees.

• In the case of individual ETFs, it is possible to draw a more favourable comparison between ETFs and investment trusts: Vanguard’s FTSE 100 VUKE ETF, for instance, offers an almost identical yield to that of City of London Investment Trust (one of the lowest-priced on the market), but at a cost that is just one-fifth of City of London’s 0.43% OCF. That said, while their investment universes overlap, they are not identical.

• ETFs aren’t as simple as is sometimes made out. Which geography or index to track, currency risk, and tax regime – even getting the right ticker – all serve to complicate life. (Investment trusts present some of these challenges too, and they usually won’t insulate you from say currency risk on your underlying holdings. But trust managers can do some of the work for you, and they can use their trust’s income reserves to smooth some of the ups and downs when it comes to the income you receive.)

• Vanguard’s ETFs are more ‘income-friendly’ than iShares’ ETFs: for investors wanting income and low costs, Vanguard looks like the place to go.

If this route is appealing to you, then you may also want to read up on using cash buffers to stabilize your retirement income from ETFs.

In my next post I’ll see what a basket of Smart Beta-style ETFs might deliver for income seekers.

Note: Data variously sourced from Vanguard, iShares, Morningstar, the Financial Times, and Hargreaves Lansdown. Do catch up on all Greybeard’s previous posts about deaccumulation and retirement.

1. Then-chancellor George Osborne pledged to abolish stamp duty for shares purchased in exchange-traded funds in 2013 to try to encourage the growth of UK-domiciled ETFs, but so far the industry has failed to respond with new UK-based launches. [↩]

The ISA has long been an incredibly attractive way for UK investors to shield their investment income and capital gains from all taxes.

The annual contribution limit has risen over the years, too. From 6 April 2017 you’ve been able to sock away £20,000 a year.

Some or all of that allowance can now go into an Innovative Finance ISA. Similar to a cash ISA, this enables you to shelter the higher income you can get from peer-to-peer platforms from tax (although big boys Ratesetter and Zopa have yet to win approval for theirs).

The ISA has also become a weapon of redistribution, albeit one with a distinctly Tory slant.

First came the Help to Buy ISA, which tops-up the savings of first-time buyers. Help to Buy ISAs became available in late 2015.

And then 6 April 2017 saw the launch of the Lifetime ISA – also known as a ‘Lisa’.

The Lifetime ISA / Lisa enables young (and young-ish) people to save up to £4,000 every year into a special new ISA wrapper. This money is then boosted by the Government by 25%.

• For example save the maximum £4,000 and they’ll give you £1,000. That would mean £5,000 went into your Lifetime ISA that year.

The money in your Lifetime ISA grows tax-free, as with normal ISAs. It can later be used to buy your first home or else be put towards retirement.

Here it is illustrated in one official government graphic:

This graphic is actually a bit misleading. It implies the bonus is static, whereas the Treasury’s own documents make clear the bonus becomes part of your total Lifetime ISA pot that compounds over the years. Also, from April 2018 the bonus will be added monthly.

Anyway, free money growing safe from taxes sounds great, right?

Well, it might be, but complications abound with the deceptively simple Lifetime ISA and there are harsh penalties if you stray off-piste.

In this article we’ll dive into the detail of the Lifetime ISA. In the follow-up I’ll look at who should make the Lifetime ISA a big part of their savings strategy, and who should probably not.

(Spoiler alert: I think everyone who can open a Lisa should do so, but in many cases with just the minimum contribution allowed. For example Hargreaves Lansdown will let you open one with just £100. This way you have it should your circumstances change, even after you’re too old to be allowed to open a new one).

The Lifetime ISA explained

Let’s run through the key points.

Opening a Lifetime ISA:

• You must be aged between 18 and 39.
• You must be a UK resident.1
• You can only open one Lifetime ISA per person, per tax year.2

You can open a Lisa if you’re just one day shy of your 40th birthday (and as mentioned I think you should).

After that, computer says no.

How much can you put in?

• You can save up to £4,000 a year into your Lifetime ISA(s).
• Any cash you put in it before your 50th birthday will receive an added 25% bonus from the government.
• The first government bonuses will be paid into your Lifetime ISA account in April 2018.
• From then on bonuses will be paid monthly.
• Once in your Lisa, the bonus earns interest (or can be invested) just like the money you contribute yourself. This nicely increases the total pot you’re compounding.
• For the 2017-18 tax year only, you can transfer savings you’ve built up in a Help to Buy: ISA into a Lifetime ISA in that year and still save up to £4,000 into your Lifetime ISA and get the government bonus.3 See MoneySavingExpert for some ideas on timing.
• You can save into a Lisa until the day before your 50th birthday. After that it can remain invested, but you can’t put new money in (and you’ll get no more bonuses).

The showstopper attraction then is you get an added £1 for every £4 you put into the Lifetime ISA per year, up to the £4,000 limit.

That’s much better than with a normal ISA, where you pay in taxed money and get no extra top-ups.

Indeed it’s free money – always the safest return.4 For the youngest Lifetime ISA savers, it could add up to tens of thousands of pounds of bonus payments over the decades (presuming the scheme survives.)

If you begin at age 18 and you save the full £4,000 a year, then at 50 you’d have saved £128,000 and enjoyed £32,000 of top-ups. (And that’s just the money that’s gone in, before any growth…)

There are no minimum or maximum monthly contributions to the Lifetime ISA. You should be able to save whatever you want each month, up to the £4,000 a year limit.

What about my other ISAs?

The larger £20,000 annual ISA limit applies across all your ISAs – Lifetime ISA, Help to Buy ISA, Innovative ISAs, and, um, Bog Standard ISAs.

For example, if you put the full £4,000 in a Lifetime ISA, you have £16,000 of your allowance leftover for the rest of the ISA gang that year.

How can I invest my Lifetime ISA money?

Qualifying investments for a Lifetime ISA are the same as for a normal ISA. Cash, shares, bonds, investment trusts, ETFs, funds – all should be fair game.

This means that unlike with a Help to Buy ISA (which is limited to cash) as a Lifetime ISA owner you can take your government-sourced money and pump prudently invest it into shares.

However there’s a snag. In theory, all those assets I listed can be held in a Lifetime ISA – but currently there are no cash Lifetime ISAs available.

This is a pretty strange state of affairs, and it won’t last if the Lifetime ISA survives.

In the meantime, if you are risk averse (perhaps because you think you’ll need the money in a few years for a house and you don’t want to risk the ups and downs of the stock market) you could perhaps open a Lifetime ISA that’s meant for shares, and invest your money and the bonus in a short-term bond ETF.

Or you could just wait for cash Lisas to become available.

How you can use your Lifetime ISA

At last the good bit! You can use the money in your Lifetime ISA in two different ways:

To buy your first home

• Your savings and interest and the government bonus – all compounded together over the years – can be put towards a deposit on your first home. This property can cost up to £450,000, anywhere in the country.5

• If you’re in a couple you can both receive the Lifetime ISA bonuses before buying together, as ISAs and top-ups are limited per person rather than per home. The maximum house price remains £450,000 for a couple, though.

• If you have a Help to Buy ISA you can transfer those savings into your Lifetime ISA in 2017-18, or else continue with both. However you will only be able to use the bonus from ONE of these two kinds of special ISAs to buy a house, which could lead to fiddly complications or decisions down the line.

This last point begs the question of what else to do with your Lifetime ISA money if you don’t buy a house?

Aha! That brings us to the second permitted use…

Put it towards your retirement / later fund

• After your 60th birthday you can take out any or all the savings in your Lifetime ISA, tax-free.

The official line is you will be able to leave the money invested if you want to after you’re 60. You should also be able to transfer your money to another type of ISA.

For example, perhaps Innovative Finance ISAs will be providing would-be retirees with a steady tax-free income and various safeguards in two decades time?

Frankly, who knows what the landscape will look like in 20 years. (Just one reason why constant government tinkering is unhelpful. It adds more uncertainty.)

Assuming the ISA regime survives until 2037 and beyond, I expect that when the first Lisa owners hit 60 there will be lots of options.

What if I don’t buy a house and I want the money before I’m 60?

Now we come to the big sting in the tail – the potential penalty charges.

You can withdraw your Lisa money without a charge if:

• It’s to go towards your first home costing up to £450,000, and it’s been 12 months since you first started saving into the Lifetime ISA.
• Or you’re over 60.
• Or you’re terminally ill.

Otherwise, you face a penalty.

• You will have to pay a withdrawal charge of 25% if you take out money at any time before you turn 60 (unless it’s to buy a qualifying house).

This charge is tougher than you might first think.

Some will see a 25% charge as simply clawing back the 25% Government bonus.

But this is not right. Here’s the maths:

Put in £4,000
Get £1,000 bonus (that is, a 25% boost).
You now have £5,000
Withdraw early, for non-permitted reasons
Take a 25% charge = 25% of £5,000 = £1,250
£5,000 – £1,250
= £3,750

You are left with less money than you put in! (6.25% less to be precise, which is the true penalty for withdrawing after taking into account the bonus).

This is a simplified example. There’s a 30-day cooling off period when you open a Lisa, and there will be no exit penalties charged in this first year. Over sensible time periods there’d hopefully be some growth in your money.

But the principle holds. You might find you have to withdraw money early – and the freedom to do so, even with a charge, is attractively flexible compared to a locked-up pension – but you really don’t want to if you can help it.

If you start a Lifetime ISA, you need to be as confident as possible that you will abide by the rules: Buy a first home with the money, or no withdrawals until 60.

Where can I get a Lifetime ISA?

Only a few providers are offering them so far. Right now Hargreaves Lansdown, Nutmeg, and The Share Centre. That’s your lot.

Seems odd, doesn’t it? Former chancellor George Osborne announced the Lifetime ISA back in the 2016 Budget. Plenty of time for platforms to get on-board – especially when they can dangle carrots of free cash from the government in front of savers.

Theories for the tardiness abound:

• Perhaps the new HMRC reporting regime for Lifetime ISAs is proving onerous?

• There are concerns over those exit penalties (belatedly softened for the first year).

• The first lump sum top-up from the government won’t be paid until the end of the year, so what’s the rush?

• Some fear the Lisa could be the next mis-selling scandal.

Then there’s my theory, which is that the Lifetime ISA is such a muddle that firms presumed it would be scrapped before launch. (A tad naive when it comes to finance, perhaps. When has confusion ever stayed the industry’s hand?)

Don’t get me wrong. The Lisa has its attractions. The initial pros and cons aren’t going to be hard for a typical Monevator reader to figure out.

However extrapolating them over an uncertain 10-30 year time horizon is harder.

Meanwhile the average young person is likely to be bamboozled from the outset.

Should you open a Lifetime ISA?

At first glance, the Lifetime ISA sounds like a Help to Buy ISA with a personality disorder, but that doesn’t mean it’s not worthy of close attention.

As it can only opened by those aged 18-to-under-40, it seems to be aimed at helping the finances (and winning the votes) of a younger generation that has seen job security, affordable housing, and generous final salary pensions disappear over the horizon.

Whether the Lifetime ISA is the best way to address wealth inequality across the generations is a topic for another day.

But if you’re young enough to qualify and you have money that you’re committed to locking away either to buy a home or for your retirement, you should give serious thought to opening a Lifetime ISA.

As I say I would definitely open one if I were under 40, even if it was only to put £100 into it. Once it’s opened, you have the option of using it once you’re over 40, and who knows how your circumstances might change? Don’t open it, and the door closes on your 40th birthday.

All that said, weighing up whether you should be directing money towards a pension (particularly a workplace pension with super valuable employer contributions), a Lifetime ISA, a Help to Buy ISA, a normal ISA, or some other form of savings will be complicated for many people.

Not least because the two uses permitted – buying a home when young, and saving for when you’re old – entail very different investing decisions.

And also because of that exit penalty, of course.

In the next post we’ll see exactly who the Lifetime ISA might be good for, and who should say “no thanks”, and back away slowly.

Note: I’ve updated this post with all the latest on the Lifetime ISA. Older comments below this post may date back to its launch. Many are still relevant, but keep that in mind.

1. Or a member of the armed forces serving overseas, or their spouse or civil partner [↩]
2. Each time you apply for a new Lifetime ISA you’ll need to meet those first two criteria. After your 40th birthday, no more new Lifetime ISAs for you! However you can continue to contribute to your existing ones until you’re 50. [↩]
3. Alternatively you can keep saving into both schemes. However note you will only be able to use the bonus from one of the ISA types to buy a house! [↩]
4. Okay, it’s not totally free as the government must get the money to top-up from somewhere, via taxes. But if you’re young it will probably be coming from taxing someone older. [↩]
5. Unlike the Help to Buy ISA, which has different limits inside and outside of London. [↩]

Good reads from around the Web.

Often it feels like the best thing to do as a writer about investing is to repeat what you said last week.

In a Bloomberg podcast I link to below, the entertaining hosts bemoan how boring the markets are right now. That’s understandable – they’re both journalists, and they want to write about drama.

Nobody becomes a journalist to say “nothing doing here, as you were”. But that’s actually pretty good advice to live by when it comes to investing.

While The Accumulator continues to labour away on his book, I’ve republished some of his old articles to remind people what we’re missing. Frustratingly, TA has a habit of putting in useful contemporaneous snippets of data when he writes (whereas I try to wax eternal, like a Poundshop Marcus Aurelius). Many of his older pieces can’t just be dusted down and passed off as new. But more than a few can, because the best financial principles are timeless.

The alternative is to just keep saying the same thing, but to try and say it better each time. This is hard. Shakespeare’s 150-odd sonnets go over the same ground as doggedly as a Roomba, but they don’t really get better as you go on. And I’m no Shakespeare.

The third approach (and the motivation for these weekly roundups) is to see how other people approach the same topics, and to applaud them when they knock it out of the park.

Which brings me to Just Keep Buying, a piece this week from the Of Dollars and Data blog. It sees the anonymous author (hey, I already feel a kinship) approach the age-old topic of dollar-cost averaging with a mix of succinct prose and revealing graphics.

This is the best bit:

If I still haven’t convinced you [to just keep buying each month] let me tell you a story.

The story is about a man with possibly the worst luck in investing history. He made a total of 4 large stock purchases between 1973 and 2007. He bought in 1973 before a 48% decline in stocks, bought in 1987 before a 34% decline, bought in 2000 before the dot com crash, and bought in 2007 before the Great Recession.

Despite these 4 individual purchases that totaled a little less than $200,000, how did he do? He ended up with a $980,000 profit for a 9% annualized return.

What was his secret? He never sold.

I’d go and read the whole article if I were you.

[continue reading…]