BLOG: Seeking Investment Income

Written by: Paul Wilcox, chairman and technical director, The WAY Group‏
Many investors, particularly the retired elderly, who are dependent on the return from their building society deposits, have now spent several years devoid of any worthwhile level of income (interest) from their deposited funds.

This income famine has also been evident in the bond markets where yields have been increasingly depressed by consistently low interest rates.

More recently George Osborne announced retirement bonds at ‘competitive rates’, targeted directly at the over 60’s, but the best gross yield of 4 per cent for 3 year bonds, only amounts to 3.2 per cent after 20 per cent income tax and the maximum investment is £10,000. So the reality is a mere £320 extra income a year, after tax, for those saving the full amount.

The real problem for many investors/savers is that they do not wish to put their capital at risk but they do need a better return than the 1 per cent to 3 per cent currently available from deposits. If investors were prepared to take a longer term view involving equity investment they could immediately increase their income returns quite dramatically. By investing in a good spread of large, sound and high-yielding shares, or by buying a small selection of high income funds (some of which blend shares and high yielding bonds), they can currently achieve a dividend yield of around 4-5 per cent.

Neil Woodford, the high profile ex-Invesco fund manager (with a tremendous track record in achieving equity income performance over many decades), launched his own equity income fund last year. It has over £4bn invested and has a minimum target yield of 110 per cent of the FTSE100. So a competitive target of 3.5 per cent compared with the FTSE yield of 3.2 per cent.

What is Income?
I know many will suggest that talk of ‘real’ investment in the same breath as interest rates from secure deposits is inappropriate, but maybe it is time for us to reconsider the whole issue of income. To most people seeking income, the desire is simply to have a reliable source of regular net cash to defray the cost of living. Of course we want to minimise any risk to our capital but being able to afford to survive and live a decent and stress-free life is the main priority.

Most reasonably wealthy investors tend not to have a singular approach to supporting their lifestyles. They tend to have a cushion of deposits to give them access to ready cash and to act as a buffer or float. While high interest rates on that cash ‘float’ is attractive, most do not rely on it. Alongside this ready money they run a diversified investment portfolio which they manage on a semi active basis to achieve two practical ends. They attempt (themselves or via their adviser) to make adjustments to their investments, to take advantage of major trends whilst also making sure they realise regular capital gains.

Capital gains should not be under-estimated in the goal of generating regular tax-efficient cash to use as ‘income’. Every individual has an annual tax-free capital gains allowance of £11,000 – a significant contribution to ‘income’ compared with the extremely modest retirement bond issue amounting to £400 per annum gross! But for those realising greater annual gains the graduated tax CGT rates are 18 per cent and 28 per cent – considerably lower than equivalent Income Tax rates.

Fine tuning the strategy
The problem for many investors adopting this strategy, of matching a cash buffer with a mixed investment portfolio, is lack of attention or lack of discipline. Either, we become caught up and distracted with other things and do not take gains when we should, or, we simply see gains building and become too enamoured (or seduced) with the progress and take no action.

The simple answer is to apply an intelligent and formulaic approach to managing this process. If one is looking for a ‘yield’ of 4 per cent from invested assets then our research recommends placing 20 per cent into cash or near-cash reserves and drawing 4 per cent a year on a regular basis – probably by standing order. The remaining 80 per cent is invested according to one’s risk appetite, and lightly managed in future. The discipline comes from regular reviews. Such a review could be quarterly, half-yearly or annually depending on how much attention one wishes to pay to the strategy.

At each review the overall portfolio is valued, including the cash reserves and investment portfolio. If the total is greater than the initial sum invested then it is time to take some profits and re-balance the portfolio back to the 20 per cent/80 per cent ratio. The advantage is that if the reviewed total valuation is higher than the original combination, then one can increase the drawing level to 4 per cent of the new total.

There need be no further hard and fast rules as to what is sold; that is a matter of judgement. The important discipline is the review itself and the decision to take an appropriate level of gains – if the review shows an overall increase. Of course, gains will also be taken and reinvested, when appropriate, quite separate to the regular, ‘re-balancing’ reviews. Many of those gains will either be tax-free (within the annual allowance) or taxable at modest rates. Meanwhile the drawings are drawings of cash which attract no tax.

Such a strategy has been shown to be effective through much of all historical investment cycles as long as it is followed over the medium to long term. It clearly receives a boost during periods of high interest rates when the cash buffer is enhanced by accumulating net interest, but this must be viewed as a bonus.

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