As part of our Seeking Income Week, we spoke to a number of independent financial advisers and representatives of financial planning organisations on how to ascertain the right income levels to pursue and what pitfalls to avoid along the way. Here are five key takeaways from our conversations.
1. Seeking Income vs. Needing Income
Investors can often mistake the concept of seeking income as an investment strategy, i.e. a value strategy rather than a growth strategy, or for the diversification benefits, with the concept of investing in order to fill a particular income gap in their household balance sheets, pointed out the Institute of Financial Planning’s Sue Whitbread.
In establishing what level of income you need, Whitbread explained that this is firstly a matter of diligent accounting of all your current and projected sources of revenue and expenditure, and secondly a matter of establishing the level of income injection you will require from your investment portfolio. From this stage of the planning process on, income investment strategies will vary between investors. And as with all investment strategies, there will be a trade-off between what level of income return you feel you need and what level of investment risk you’re willing to take to get it, pointed out Martin Bamford, Managing Director of Informed Choice.
When investing with the objective of generating regular income contributions, said Bamford, an investor can either rely on yield-generating assets (such as dividend-paying equities, bonds, or funds) or buy into products that offer exposure to capital growth from which you can take regular capital withdrawals as ‘income’.
2. Beware the Risks of Inflation and Capital Erosion
Consider the impact of inflation and plan for the real return on your investments, rather than the nominal. It is sometimes all too easy, Whitbread said, to buy an annuity and forget the level of income erosion inflation can inflict on the returns you are looking to receive. In addition, as current savers know only too well, in an inflationary environment cash account interest rates may yield negative real returns, so your invested assets need to work that much harder.
Inflation also impacts the way individuals perceive the value of financial advice, points out Whitbread. On the one hand, the unattractive return on cash holdings prompts savers to look for more complex investment schemes and consequently seek advice, but on the other, paying for financial guidance with your harder-earned cash creates higher demand for extracting real value from the advisory service you pay for.
Sticking with cash and accepting capital erosion or exposing capital to higher levels of investment risk is a tough decision, commented Bamford, and cautious investors are the ones most likely to suffer in an inflationary environment where low interest rates are maintained. He also added that in the current climate historical yields are likely to be a poor indication of future yields, and investors have to be prepared for a higher than typical amount of income and capital volatility.
3. Be Mindful of the Taxman
Tax is often one of the biggest challenges for income investors, particularly those with earned income in addition to their investment income, said Bamford. The current UK government introduced an additional rate of high-earner income tax at 50%, which has made investment income very unattractive for the wealthiest investors. According to Bamford, the way to address this challenge is careful planning and thoughtful accounting, including dividing portfolios between husband and wife, or making full use of allowances and exemptions.
Tax efficiency should also be observed in picking an income-yielding investment strategy, he said. For example, investors who want to opt for the certainty of fixed levels of income withdrawals need to be mindful of their capital gains allowance, sticking within which can make a capital growth and withdrawals strategy attractive.
4. Stick to the Basics and Diversify
Whitbread says that most of the IFP’s members would recommend seeking income in the traditional asset classes: cash, bonds, equities and property. She has observed a real change in trends away from products such as guaranteed income bonds or guaranteed distribution bonds, which were more popular in the past. Whitbread has also observed the re-emergence of interest towards structured products, but believes that these vehicles are still seen as having a degree of excessive complexity and their shortcoming were proven all too clearly during the credit crunch.
Bamford and Whitbread both agree that diversification across the asset classes is key. It is for this purpose that Bamford notes the benefit of allocating a portion of your portfolio to real estate, given that the correlation characteristics of real estate to other holdings in an income portfolio are essential from a risk management perspective.
5. Steer Close to Home and Bet on a Navigator
In terms of seeking income across the globe, Bamford explains, the UK tends to be the basis for most equity income decisions. Dividends paid by UK companies are typically higher than those paid internationally, for a variety of historic reasons including the taxation environment. However, it’s worth noting that the international nature of the FTSE 100 companies means that even those who think they’re investing solely in the UK are in fact tapping into international opportunities. Furthermore, globalisation means that a country-by-country view of the world is less relevant these days, instead investors view the world sector-by-sector. But when it comes to picking sectors and international stocks for income, Bamford believes these decisions are best left to the fund managers, who can adjust their allocations depending on the economic environment.
In addition to the benefits of selecting a trusted financial adviser and picking experienced fund manager, we at Morningstar are big believers in the value of individual investment education. To this end, our Seeking Income special provides insights into reaching for yield across all the basic asset classes and investment vehicles.
Picking Your Own Dividend-paying Equities
UK Equity Income OEICs
Real Estate
Fixed Income
Fixed income ETFs
Income Yielding CEFs
Manager View: the Global Income Environment
