INVESTING for income rather than capital growth is often an issue faced by individuals moving into retirement. They have worked hard building up cash, pension funds and investments during their working lives and, now employment income has ceased, wish to use these pension and investment resources to supplement their retirement income.
This is an important area and one that is often overlooked so, in this article, I am attempting to provide some further insight into this particular subject.
One should be aware that taking an income from an investment means investing in a different way to being invested for all-out capital growth. To start, I think it’s important to look at the key things you need to know first if you’re thinking of investing this way.
1. Income is derived in three main ways
Income is a rather generic term. However, when it comes to investing, income is generated in three main ways:
- Interest. When you deposit money with a bank or building society, they get to use your money for their own ends: lending out to borrowers and investing in their own projects, etc. The bank pays you for the privilege and this payment is called interest. Also, if you hold gilts or corporate bonds, the income from these is interest. Gilts and corporate bonds can be bought directly or, more commonly, via a collective investment fund.
- Dividends. When you own a share in a company, and the company makes a profit, part of that profit is often distributed to the shareholders. That payment is called a dividend. It is not just shares that pay dividends, but also collective investment funds, which will own shares within the fund that create dividends.
- Rental income. When you own a property which is rented out, the money your tenants pay you is called rental income.
It is worth recognising that each of these types of income is different, particularly from the point of view of the tax man.
Each of the methods shown above has its uses, advantages and disadvantages, but the end result is the same – money is generated by the asset you hold, be it a cash deposit, a holding of bonds, shares or a bricks-and-mortar property, and that money ends up in your bank account to be spent as per your requirements.
2. Natural income and total return
Many people think that when investing, the only way to think about income is what financial advisers would call “natural income”.
Income from a bank deposit is produced by the deposit and can either be added to the deposit holding, or paid out to your bank account. Likewise, a dividend can be used to buy more shares or units, or can be paid into your account.
The natural income is the income produced by the asset. Often, but not always, the natural income will fluctuate. For many people who are depending on that income to live, and the income fluctuates or goes down, then there is a potential problem as it is difficult to budget around a fluctuating income.
However, my preference is to educate investors to think about income as total return. Put simply, I would urge you to think of total return as the combination of both natural income, and the increase in value of the asset itself.
Now I should point out that this does not apply to bank accounts. The reason is that if you skim off the interest from a bank deposit at the end of the year, you will have exactly the same amount at the end of the year as you did at the start. The cash in the bank can’t grow in addition to the interest paid on it.
I should add that the interest can be added to the balance, meaning that in year two you get interest on interest, but each pound is only ever worth a pound.
Money in the bank cannot provide capital growth in addition to the payment of interest.
However, shares and property can grow in value, quite apart from the fact that they also throw off dividend and rental income. So using these asset classes, you have two strings to your bow.
A share with a value of £1,000 might throw off a dividend of £20 over a year. It might also increase in value from £1,000 to £1,030 over the same year. My total return then, ignoring inflation and tax, is £50, or the sum of my growth and my dividend.
Thinking in terms of total return has far-reaching implications for those investing for income.
If you can harness both growth and natural income to fund your lifestyle, it gives you dual benefits with which to work.
3. Safe withdrawal rate
This term refers to the rate at which you can draw money from an investment portfolio, and never have the portfolio itself run out.
Thinking back to the share mentioned previously that provided a dividend and grew in value, you know that you could withdraw £50 from that portfolio in that year, and you would still have the same amount of money in the pot that you had when you started. All you have done is siphon off the profit and the dividend.
But what if you needed £50 to live on next year, but in year 2 the value of the £1,000 dropped to £950 and the dividend was only £10?
In this example you have actually lost £40 on your capital and you have also withdrawn £50, so your pot of money is well down.
Shares and similar investments do not perform in straight lines: they go up and they go down.
If you withdraw money when your shares are suffering, you damage your wealth more than if you take money out of profit. This is a kind of reverse pound cost averaging.
The safe withdrawal rate then is a guide to how much you can withdraw from a portfolio and, assuming normal levels of investment volatility, you should never run out of money.
The safe withdrawal rate depends very much on the state of markets when you begin taking that income.
4. Income is a compounding agent
When income is added to income, and you also throw asset price growth into the mix, you have a great recipe for compounding – this is the snowballing of money so that it gets bigger, faster.
However, this can never happen if you spend all the income produced by an investment.
All you have left is the asset value which can go down and up, but which can never be added to by buying more of the asset.
It is important then to consider using compounding to your advantage and not to get hung up on income in the simplistic form of the word.
Taking natural income is fine, particularly if you can cope with a fluctuating income and if you have sufficient assets at your disposal, although most of us will need to find a method of working what we have as hard as possible. Using income as a compounding agent is a key way to do that.
Investing for income is essentially about having a desired level of income being generated by a portfolio, and making sure that income can be sustained for the rest of your life. There are many variables, as we’ve discussed, and there will inevitably be some compromise on your part as things won’t always run smoothly.
That being said, with careful planning and managed expectations, it is entirely possible to invest in such a way that provides a sustainable, predictable level of income or withdrawals into your bank account in order for you to get on with living your life, which is the whole point of financial planning in the first place.
As ever, I will counsel you to seek advice from an independent financial planner who can help you set realistic expectations and make a detailed financial plan on how best to achieve your desired objectives.
