Investment funds for a secure income: annuity proxy picks

Investment funds and trusts can’t match annuity security or bond solidity, but some can come close, writes Cherry Reynard.

For many years annuities were the mainstay of any retirement income plan. Investors swapped their carefully nurtured pension pot for a guaranteed income for life and didn’t have to think too hard about their finances again. However, annuities have some notable downsides, not least that all the capital disappears on death, and that annuity rates look decidedly anaemic in the low-interest rate environment.

Pension freedoms introduced in 2015 did away with the requirement to buy an annuity. Never ones to miss a trick, investment management groups launched a raft of new funds designed to fill the void annuities once occupied – absolute return, multi-asset income and distribution funds. They also re-badged some of their existing income-first products as ‘annuity lite’ solutions for this brave new era.

- How to generate a sustainable monthly income from your investments

Yield headwinds

However, these also come with problems. With yields on government bonds low historically, there is really no way to get an inflation-adjusted guaranteed income for life with any product other than an annuity. Everything else comes with the risk of income volatility. And while the capital risk may not seem to matter much – capital is lost anyway with an annuity – investors need to retain sufficient capital to carry on generating income for as long as they need it.

Eugene Philalithis, portfolio manager of the Fidelity Multi Asset Income fund, outlines the problem: “Income investors continue to face systemic headwinds that cannot be ignored. By now investors are well accustomed to the term ‘reach for yield’, where aggressively expansive monetary policy has driven yields to historically low levels and pushed investors further up the risk spectrum to continue earning attractive natural yields (yields paid out of income, not capital).

“Developed market bond yields are becoming less and less attractive, and even Italian and Greek 10-year yields are below 1%, due to a combination of low growth prospects and demand for positive-yielding assets in the eurozone.”

Gary Potter, joint head of multi-manager at BMO Global Asset Management, says that where fixed-income assets pay an income, investors are generally asked to take considerable risk in exchange for that income. He adds: “Obvious yield-seeking places don’t deliver. Investors aren’t going to find the answer in high-yield ETFs just because they seem to have a high yield. They have a lot of risk. Much of fixed income is a no-go area. Investors need greater security.”

This is a challenging backdrop, and no one in the clever product development teams of investment management groups has been able to manufacture a single product that replicates a guaranteed income for life with zero risk. That said, all is not lost. Some products come close by recreating the reliable income flow of an annuity while minimising risk. Moreover, through the magical alchemy of diversification, combinations of other products can have annuity-like characteristics.

Key comparisons for lifetime annuities and fund proxies 

Notes: Ranked by historic yield. IT = investment trust. All funds held in drawdown portfolios can be passed on to the next generation. Assets are passed on tax-free if the holder dies before age 75. After age 75 beneficiaries pay tax at their highest income tax rate. If death benefits aren’t attached to the annuity at the outset, the income is lost on death. Source: Trustnet to 2 March 2020

Twin goals

Most income-first products nevertheless make capital preservation an additional goal. This ensures that they don’t succumb to ‘pound-cost ravaging’ (where income needs to be drawn from an ever-dwindling pool of capital) and that investors have something to leave to their family – or the local cats’ home, depending on their preferences – when they no longer have any need for income. This is the key reason investors pick this type of solution over an annuity.

These income-first options come in a variety of guises, and the right option for investors will likely depend on the level of personal involvement they are prepared to commit to.

For those who really don’t want the hassle of managing and monitoring a portfolio of funds, there are multi-asset or fund-of-funds options. John Husselbee, head of multi-asset at Liontrust, says: “These funds will target an income, and there are usually three variables: return, risk or time objective. There may be an inflation target (we target inflation plus 4% or similar) or a certain level of volatility.” Those with time targets will shift the asset allocation over time to reflect their changing risk profile as they age.

Choice core holding

Hawksmoor Distribution is tipped by Gavin Haynes of Fairview Investing. He sees it as an ideal core long-term holding for annuity-hunting investors who want a well-managed range of funds diversified across financial markets and asset classes. The fund, managed by Dan Lockyer and Ben Conway, currently yields 4% and targets long-term capital growth.

Plenty of big players also operate in this area. The multi-manager team at BMO Global Asset Management has its distribution fund; Fidelity runs a global multi-asset income fund; Baillie Gifford has a multi-asset income fund where the priority is the safety and resilience of income, while preserving capital. For those who want a sustainable option, there are now the Aviva Investors Sustainable Income and Growth and the BMO Sustainable Multi-Asset Income funds.

These vary in the extent to which they invest directly or through other funds (which will influence costs), the extent to which they prioritise income versus capital growth, and the skill of the manager. Low-involvement investors who pick a good fund should be able to sit back and draw their income.

Husselbee says investors who want to pick funds themselves – a higher-maintenance option – will need to do some fund manager research and ongoing monitoring. A solution isn’t likely to be found in a single fund, but in a blend of funds: probably a core of equity income, and diversification into bonds and other assets, including closed-ended funds.

Nevertheless, there is the odd exception. The Tenax Absolute Return Strategies fund was launched with just this type of investor in mind. Sam Liddle, sales director at Church House, says the fund was launched in 2007 to provide a safe place for £10 million of proceeds realised by a client of Church House from the sale of his business: “The client invested his capital via an offshore bond, and has since taken quarterly withdrawals of income and capital amounting to 4% a year of the value of his capital. Over the past 12 years, the clients’ capital has increased in value and he has enjoyed a steadily rising income.” Liddle adds that the low volatility of returns has made this possible by reducing the risk of pound-cost ravaging.

Capital ideas

Such funds are relatively rare among open-ended funds, but Kepler Investment Intelligence has identified a number of investment trusts it believes fit the bill as annuity proxies.

Kepler annuity income choices: Tetragon, Invesco Enhanced Income, Hipgnosis, Greencoat UK Wind, Henderson Diversified Income, HICL, Real Estate Credit, TwentyFour Income

These trusts cover infrastructure (HICL, Greencoat UK Wind), fixed income (TwentyFour Income, Henderson Diversified Income) and multi-asset (Tetragon), plus some niche opportunities such as in song rights (Hipgnosis).

Kepler says: “Our annuity income picks are aimed at those who prioritise yield over everything. While we hope to at least maintain capital values in inflation-adjusted terms, we are willing to accept the risk of a slow erosion of capital if necessary. Our picks have generated an average NAV total return of 9.3% over the year and an average share price total return of 13.4%, with the majority of the total returns clearly coming from income.”

Most of these trusts have produced a long-term, regular income stream. Where the income has occasionally been cut, it hasn’t been by much. For example, the Henderson Diversified Income trust saw its quarterly dividends rebased in November 2017 from 1.25p to 1.1p in response to the lower yields available in the market. However, the shift meant the dividend was covered by earnings and is now growing again.

Potter says some of the best income opportunities can often be found in niche asset pools such as infrastructure, specialist property and smaller parts of the stock market. However, for the income to be reliable, these assets need to be used in combination.

He adds: “Combining them is a very sensible way to take the risk out of income delivery. Just buying infrastructure assets on their own is quite high risk. In general, it is a good income asset class where income is higher and enshrined in the investment philosophy, but if the Labour Party had won the last election, these assets would have been in danger. The solution is to combine dependable areas of income.”

If an investor isn’t comfortable delving into these niche asset classes solo, Haynes suggests the RM Alternative Income fund, which can act as a good diversifier for an income portfolio. He says: “With traditional income-generating assets such as bonds and property offering miserly yields, investors are having to look elsewhere for income. I like this fund. It provides exposure to a broad range of listed securities following three broad themes: specialist lending, infrastructure and specialist property. The fund targets a 5% yield.”

For those looking for more-vanilla equity income options, it may be worth bearing in mind that income opportunities aren’t necessarily to be found in the most obvious areas. Potter points to equity income offerings from groups such as Chelverton (smaller companies) and Prusik (Asia), where yields are 4-5%. “Certainly, the dividend yield would be reduced if there was a major slowdown in markets, but these are chunky yields. Even if the market comes off 20%, the yield is likely to be reasonably safe.”

Philalithis agrees that looking globally is an advantage in both stock and bond markets: He says: “In 2018 and 2019, for example, allocating between high-yield regions based on their respective risk and return profiles helped contribute to the portfolio. Asia high yield continues to be our favoured high-yield region, and against the market dislocations from the coronavirus it has performed strongly.”

Husselbee points out that investors have a third option: to use equity and bonds directly. “This may be the cheapest option, but it takes time, experience and confidence. Investors may rather be enjoying their retirement.”

In reality, the only thing that delivers a guaranteed income for life is an annuity, and if that is what an investor needs, they should simply shop round for the best option. However, it is possible to find a close-second option that provides a reasonably consistent income stream with the added bonus of capital back at the end through a variety of means.

An investor’s real choice is around the amount of work they want to do. There are multi-asset options for the disengaged, but also a wide range of single-fund options for those who would rather get into the realm of fund selection.

Five scenarios where buying an annuity makes sense

Annuities have been out of fashion. Low interest rates have made them look poor value, while retirees have grown increasingly uncomfortable with the idea that an insurance company gets the bulk of their pension pot should they die early in retirement. Nevertheless, there will be times when buying an annuity is the right thing to do.

When you still have dependants and/or debt: if you have large debts such as a mortgage to pay off, or are still paying education fees, it can make sense to opt for a guaranteed source of income. You don’t have to use your whole pension pot to buy an annuity, but it can be worth ensuring that you have enough income to pay for the important stuff.

When you have no other sources of income to pay the bills: if you have other income – a buy-to-let property, say, or a large Isa portfolio – you can afford to take greater risk with your retirement income. If your pension pot is your only source of retirement income, think twice.

When you get older: annuity rates rise markedly with age, because the annuity is less likely to be paid for long. A £100,000 pension would buy a non-increasing income of around £4,140 a year for a 60-year-old, according to Hargreaves Lansdown, but this rises to £7,115 for a purchase at age 75. You may decide at a certain point that you need more security than an investment-based income can provide.

When you have care costs that need paying: these can creep up later in life, at which point it may be worth swapping a drawdown portfolio for an annuity. Care home costs are notoriously expensive and not something you can risk.

When you are in good health: If you’re in poor health, you may get a higher annuity rate. But those who do best out of annuities over the long term are those who live the longest. So if you’re in good health, have a family history of longevity or perhaps just feel lucky, an annuity might be the answer.