Generating an income from your investments

An important requirement, especially if you’ve
retired or are approaching retirement

How do you generate a reliable income when interest rates are stuck at all-time lows and the Bank of England’s quantitative easing policy of ‘printing’ money is squeezing yields on government bonds (gilts) and other investments?

Your ability to generate income
With more of us living longer in the UK, maintaining our standard of living in retirement and funding holidays and outings requires some careful planning. Have you considered how a longer lifespan and rising inflation could affect you and your ability to generate income?

Generating an income from your investments will be an important requirement, especially if you’ve retired or are approaching retirement, or if you need to supplement your salary or have a relatively short investment timeframe.

Fixed interest
The most popular forms of income investment are bonds (which are also known as ‘fixed interest’ investments) and cash, both of which pay a regular, consistent rate of interest either annually, twice a year or four times a year. You can also obtain an income from shares in the form of dividends, and many equity funds are set up solely with the purpose of generating a stable income. Importantly, equity income funds often aim to achieve not only stability, but also an increasing income in the long term.

Good cash flow
Income stocks are most usually found in solid industries with established companies that generate good cash flow. They have little need to reinvest their profits to help grow the business or fund research and new product development and are therefore able to pay sizeable dividends back to their investors. Examples of traditional income-generating companies include utilities, such as oil and gas, telephone companies, banks and insurance companies.

You should remember that these investments do not include the same security of capital that is afforded by a deposit account.

10 income investing tips

1 Sustainable long-term dividend growth – Investing in businesses when the growth potential is not reflected in the valuation of their shares not only reduces the risk of losing money, it increases the upside opportunity.

2 Inflation matters – Always bear in mind the detrimental effect of inflation. Corporate and government bonds offer higher yields than cash but returns can be eroded by inflation. Investment in property or equities provides a vehicle to help achieve an income that rises to keep pace with inflation.

3 Consider international diversification – A small number of UK companies account for approximately 40 per cent of UK dividend payouts. This compares with over 100 companies in the US, for example, that provide the opportunity to increase the longevity of dividend growth.

4 Patience is a virtue – Investing for income is all about the compounding of returns for the long term. As a general rule, those businesses best placed to offer this demonstrate consistent returns on invested capital and visible earnings streams.

5 Reliability is the key – Select sectors of the equity market that do not depend on strong economic growth to deliver attractive returns to investors.

6 High and growing free cash flow – Look for companies with money left over after all capital expenditure, as this is the stream out of which rising dividends are paid. The larger the free cash flow relative to the dividend payout the better.

7 Dividend growth – In the short term, share prices are buffeted by all sorts of influences, but over longer time periods fundamentals have the opportunity to shine through. Dividend growth is the key determinant of long-term share price movements – the rest is sentiment.

8 Cautious approach – Profits and dividends of utility companies are at the whim of the regulator. Be cautious of companies that pay a high dividend because they have gone ex-growth – such a position is not usually sustainable indefinitely.

9 Investment diversification – The first rule of investment is often said to be ‘spread risk’. Diminishing risk is particularly important for income-seekers who cannot afford to lose capital.

10 Tax-efficiency – Increase your net income by using an ISA (Individual Savings Account). The proceeds from ISA income is free of taxation, thereby potentially improving the amount of income you actually receive. UK dividend income has been taxed at source at the rate of 10 per cent and this cannot be reclaimed by anyone. The proceeds from ISAs are also free from capital gains tax, allowing you to switch funds or cash in without a tax charge.
The economic environment has been particularly unforgiving for investors who need to generate an income. The Bank of England reduced interest rates to a record low level as the financial crisis deepened – and savings rates followed.

Past performance is not necessarily a guide to the future. The value of investments and the income from them can fall as well as rise as a result of market and currency fluctuations and you may not get back the amount originally invested. Tax assumptions are subject to statutory change and the value of tax relief (if any) will depend upon your individual circumstances.

One of the biggest purchases you’ll ever make

This important one-off decision has long-term consequences if you get it wrong

If you save through a private pension, when you approach retirement age you’ll have to decide what to do with the pension fund you have built up. If applicable to you, one option is to buy an annuity. It’s important to find an annuity that suits you and provides the best deal because, after your property, an annuity is probably the biggest purchase you will ever make.

An annuity is the annual pension that many people buy with their private pension pots when they retire.

Purchasing your annuity is an important one-off decision that has long-term consequences if you get it wrong. You may not receive the best deal if you just take the annuity offered by the insurer that has been investing your money.

Lack of advice might be costly
You only have one opportunity to shop around for your annuity. Once you have committed to an annuity provider and started to receive an income, the decision can’t be reversed. So it is essential that you shop around and obtain professional financial advice to help you through the process.

Last year, the National Association of Pension Funds (NAPF) announced that the lack of advice in this area might be costing half a million retirees each year as much as £1bn in future pension income.

Failure to shop around
The NAPF pointed out that the failure of someone to shop around – or being unaware they were able to do so – might reduce their annual pension income by a third.
The insurance industry has now agreed to reform its annuity practices, and from 1 March this year insurers will have to conform to new guidelines set down by the Association of British Insurers (ABI).

New guidelines will require insurers to:

Provide clear and consistent information, including details on how to shop around for an annuity

Highlight the details of enhanced annuities – the higher pension income available to those with shorter
life expectancy

Signpost clients to external advice and support
that is available

Give a clear picture of how their products fit into the wider annuity market

The point of retirement
Insurers have been obliged since 2002 to draw their clients’ attention to the fact that they can shop around for an annuity at the point of retirement.

One of the ways in which people may end up with too small an annuity is by not taking into account their own medical circumstances. Having conditions as seemingly manageable as high blood pressure or diabetes could qualify you for an enhanced annuity, which could pay you more income because your average life expectancy may be less.

Live better in retirement
If you are approaching your retirement we can take you through the process step by step to find the best annuity for you. Your retirement should be a special time when you do those things you never had the opportunity to do before. So it’s essential you think and plan carefully, as the decisions you take now cannot be undone later. If you are concerned about your retirement provision, please contact us to review your current situation.