Mark Carney, the Bank of England Governor, delivered good news to the markets with his recent cut in interest rates (and further quantitative easing). It may have been good news to markets but was it good news for people trying to generate income from their investments? Certainly not good news for those relying on bank interest. To generate £10,000 of income (less than half of National Average wage) with an interest rate of 0.1% you would have to deposit £10,000,000. This is over ten times the maximum that an investor is allowed to have in their pension fund – let alone the fact that the vast majority of people will get nowhere near the maximum allowed.
So what can investors do? How can they make sure they have a sustainable income in the long run?
A history of income
- 20 years ago designing an income portfolio was reasonably straight forward;
Gilts (UK Government bonds) were paying a healthy running yield and were low risk; - Equities had a lower dividend yield but offered some growth potential and protection against inflation;
- Property was somewhere in between
So a “sensible” long term income portfolio would have say 50-60% in Gilts, 20-30% in equities, 10-20% in property and some cash.
Starting today that portfolio would be yielding less than 2.0% (and that is before charges). And many would argue, that with Gilt yields so low by historic standards, they are much higher risk than many realise (if the yield rises on a bond then the price falls).
Yield chasing?
So what might an investor do? One solution would be to move out of Gilts into other bonds. Corporates bonds, high yield and emerging market debt all offer higher income – but at what capital / liquidity / exchange rate risk? And once again, the fact that many investors have been chasing these higher yields has pushed prices up and up – this may all end in tears.
Certainty?
One option might be for an investor to buy an annuity. These provide a guaranteed level of income but the investor gives up the right to access capital as an annuity is effectively paying interest and returning some original capital each month. Again, these products are based on Gilts and Corporate bonds so yields have come down and down and now offer poor value by long term standards. This fall in yields is part of the reason that the requirement to buy an annuity at retirement has gradually been relaxed by successive governments.
Paying dividends
While bond yields have fallen, dividend yields from equities (UK Equities at least) has stayed much more consistent – the yield on the FTSE All Share is currently around 3.5%.
And dividends have long been a key element of the return that investors receive for holding equities. According to the Barclays Equity Gilt study 2016, the value of £100 invested in UK Equities since 1945 would be worth £251 if dividends had not been reinvested but an amazing £5,115 with dividends reinvested (in real terms i.e. after inflation). The corresponding figures for Gilts are £2 (yes just two pounds) and £220 with interest reinvested (again after inflation).
In more recent times even if you had taken all the dividends, an investor in the FSTE All Share from 1989 to the trough in 2009 would still have a return of over 66%. (source: Premier Asset Management).
To try to capture these facts many managers launched Equity Income funds during the 1990s. And it has worked, according to the Investment Association the UK Equity Income sector average (in which funds must pay a yield greater than 110% of the FTSE All Share yield), has outperformed the wider UK All Companies (Growth) sector average by over 70% in the last 20 years.
So perhaps a range of Equity Income funds would give us a higher income and some diversification – but a word of warning. According to Capita just 20 companies generate 70% of the dividends paid in the UK market by value – so most income funds hold the same stocks – so much for diversification!
Today’s portfolio?
If, today, we held a portfolio of 40% UK Equity Income, 20% Global Income, 20% UK Corporate Bonds and 15% UK Commercial property and 5% cash the yield would be close to 3.7%pa. And so long as you don’t need to access the capital this should also give a good protection against inflation and has reasonable asset class diversification – but no portfolio is immune to yield rises or market fluctuations.
Income doesn’t have to be taxing
One simple thing that many investors forget is making sure that they have the right asset class in the right tax wrapper.
Individuals in the UK have a £1,000 personal savings allowance, which many people use for cash, but can work just as well for bond or bond fund holdings.
In addition, they have a £5,000 dividend allowance, an £11,000 income tax allowance, a capital gains tax allowance of £11,100, take withdrawals from ISAs tax free and tax deferred amounts of 5% from life assurance bonds.
By holding bonds to use your interest allowance, annuity or pension income to use the personal allowance, high yielding equities to use the dividend allowance etc. it is possible maximise these allowances to take over £35,000 per year tax free (which represents a yield of around 5%).
Diversify, make it tax efficient and keep costs low
So a good plan for long term income might include:
- diversifying your assets in a way that maximises the return for the risk that you are prepared to take,
- consider running a portfolio for long term growth and consume the income and some of the capital,
- making sure you use all you tax allowances (putting the right asset in the right tax wrapper),
- and keeping investment costs low (every pound in cost is a pound that is lost)!
And if you are in any doubt – there is no substitute for good professional financial advice.
For further information please contact 1st Financial Foundations on 01908 523 420 or email info@95.154.196.167.
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