Strategies for Income Investing
Strategies for Income Investing
With thanks to Mark Dampier from Hargreaves Lansdown.
Pension Income Drawdown involves taking control of your retirement income and deciding where to invest it. It is not the kind of plan where you can sit back and let it run itself. You’ll need to think about your income requirements carefully, choose your own investments and then review things regularly. Also, be prepared for dips in the value of the fund as well as potential rises. That’s true for any investment, but the difference with drawdown is that it’s harder to make back investment losses when you’re reliant on those same investments to provide income, and when you are no longer working. Depending on the size of your pension, and the income you draw, you may need to stop taking the income for a period (18 months say) while values recover. If this would be impossible, or if you cannot face the prospect of losing money, drawdown probably isn’t for you. Consider keeping some cash aside as a buffer, perhaps from the tax-free cash taken when you first go into drawdown.
TWO STRATEGIES FOR INCOME
One option is to take the natural yield – an approach favoured by many advisers. Another option, and certainly a higher risk one is to draw from the capital (i.e. selling investments to generate an income). Alternatively you may not require any income at all and can afford to leave the fund to grow. Your own strategy will depend on your circumstances and goals, but every investor should remember that investments should be held for the long term and be reviewed regularly.
LETTING A PORTFOLIO GENERATE ITS OWN INCOME: NATURAL YIELD
Withdrawing just the income generated by the underlying investments is known as taking the ‘natural yield’. This leaves the underlying investments intact, improving the prospects for capital growth and a rising income over time although both capital and income can fall as well as rise. There are a number of ways to generate income within a drawdown account: for instance dividends from shares, or income paid by bonds. You could buy the shares or bonds directly. Alternatively you can use a skilled fund manager to make the decisions for you. I prefer the latter because I believe the direct approach is perhaps a worrying and certainly time consuming strategy, and can be volatile. A fund also allows you to leave the day-to-day investment decisions to a professional fund manager.
WHY EQUITY INCOME?
When it comes to generating a natural yield, many clients choose equity income funds. An equity income fund will generally hold shares in businesses that are expected to grow their dividends over time. Many offer a starting yield of around 3% to 4% (variable and not guaranteed), whilst offering potential for capital and income to grow. The skill is in choosing businesses with the prospect of capital and dividend growth. Equity income funds are perennially popular. For this reason many fund management groups have a flagship equity income fund, run by some of their best managers, with significant resources at their disposal to help deliver strong performance. It is important not to put all your eggs in one basket however. UK equity income funds may be a natural starting point, but consider looking further afield at global funds, for instance.
CORPORATE BOND FUNDS CAN ALSO GENERATE INCOME
Corporate bond prices have generally risen since the lows of 2008 and while the market has been volatile, those who kept their nerve have prospered. Bonds can also provide useful diversification to a share portfolio. That said, historically low interest rates have pushed bond prices up, and when interest rates start to rise again then bond prices will almost certainly fall. That is why we prefer strategic bond funds, which seek to invest in different types of bonds from investment grade to high yield and government debt. These funds offer some of the benefits of a traditional corporate bond funds, but the broad investment remit should help shield investor from some of the worst of the falls. Like all investments however, values will still fall as well as rise and income will vary over time.
DRAWING FROM CAPITAL – TAKING MORE THAN THE NATURAL YIELD
For some investors the natural yield won’t provide sufficient income, so capital withdrawals are necessary. There are inherent risks with this approach – withdrawing capital when a portfolio is falling in value will compound losses, which is what would have happened in 2008, 2001 and further back in 1987. You will see from our case study in the drawdown guide that taking money out when the market is falling can surprisingly quickly
erode the value of the remaining capital.