For investors on the lookout for investments that provide a regular income, the hassle-free route is funds that pay monthly. But as David Prosser points out they are no silver bullet.
Many people depend on investments to generate income that they then rely on for living expenses – in retirement, or even before. But there’s a practical problem with this; while most people are used to managing their finances on a monthly basis – as their salary comes in – investments usually pay income much less frequently.
If you own shares or hold an investment fund, the normal practice is an annual income distribution paid quarterly or twice a year.
The good news is that the investment industry has tried to respond to this issue. More than 100 open-ended funds now offer the option of receiving monthly income payments. These funds will automatically generate a stream of cash that you know will land in your bank account each month.
Typically, funds do this by holding back the income earned by their portfolios and then paying it out month by month. Investors usually get 11 equal monthly payments, with the fund manager smoothing out income distributions; in month 12, they receive whatever income is still to be distributed. This makes managing your money more straightforward, since you know how much income to expect from your investments each month.
Drawbacks of monthly income funds
So far, so good, but is there a price to pay for the convenience of a monthly flow of income? Well, one obvious drawback to this approach is that you’re picking a fund on the basis of how it pays out returns, rather than its potential to generate superior returns. By limiting yourself to the universe of funds that offer monthly income, you may miss out on other funds that deliver much better overall performance.
“Income generation may be at the cost of capital appreciation, leading to lower total returns, especially in the bull market,” points out Dzmitry Lipski, head of funds research at interactive investor.
“Also, inflation decreases the purchasing power of income investing, which tends not to keep up with inflation nearly as well as lower-yielding growth stock over the long term.”
Indeed, while four funds offering monthly income do appear in interactive investor’s Super 60 investment ideas – Man GLG Income Professional, Balanced Commercial Property Ord (LSE:BCPT), Fidelity Multi-Asset Income, and Artemis Monthly Distribution – the other 56 funds in this list of recommended funds don’t come with this feature. If a monthly income payment is a must for you, you’re automatically ruling out all these other funds.
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A related problem is that to produce plenty of income, monthly income funds tend to be heavily weighted towards assets that throw off dividends and distributions. As a result, if you’re looking for exposure to other types of asset, it may be hard to find a monthly income option. Relatively few such funds invest wholly on the stock market, for example, which may not generate sufficient income. Fixed-income securities and property are common focuses.
“Income-producing funds are naturally forced into investing into certain asset classes which generate high levels of income,” warns Scott Turton, a director of independent financial adviser Rowley Turton. And while fixed-income assets such as bonds, and holdings such as property, are often regarded as less risky than investing in the stock market, this is not always the case.
“We have seen over the last three years that this strategy can bring with it much higher levels of risk and volatility than might be expected,” Turton points out.
Regular income strategies tend to give a smoother ride
The counter argument is that the past few years have been an exceptional period, given the challenges of the pandemic, war in Ukraine and strengthening economic headwinds. “Investments that pay dividends frequently tend to have less portfolio volatility,” says Lipski. He adds: “And during bear markets, investments that can generate monthly income are deemed to be more appealing to investors.”
Still, Philippa Gee, the managing director of Philippa Gee Wealth Management, is concerned that the managers of monthly income funds may find themselves forced to chase the income they need. “The more pressure on a fund to produce a higher level of income or a more frequent payment basis, the further it restricts the range of stocks it can invest in – and the more risk a manager might have to take to achieve those goals.”
Other ways to generate a monthly income
For some investors, these downsides may feel like an acceptable compromise. If your absolute priority is to generate a reliable monthly income, rather than to maximise total returns, a monthly income fund could be a good option. For others, however, it may make more sense to secure access to monthly payouts in a different way.
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Scott Turton suggests a DIY approach to the problem. He explains: “Generally we’d prefer a total return approach with the required income being funded by regular withdrawals from the portfolio rather than relying on the income generated from the underlying investments.
“We consider this a better option as it allows investors to have a much more diversified portfolio.”
In practice, this simply means building a good spread of investments that you expect to deliver strong long-term performance, and then making withdrawals from your holdings each month. Sometimes, you’ll be withdrawing only the income that the portfolio has generated; in other months, you may also be withdrawing capital. But the distinction will be largely irrelevant for most investors.
Investment trust tactics
Investors can also look beyond open-ended funds. Four investment trusts – Balanced Commercial Property, Ediston Property Investment Company (LSE:EPIC), NB Global Monthly Income (LSE:NBMI) and TwentyFour Select Monthly Income (LSE:SMIF) – offer monthly income distributions, although this does limit you to funds invested in either property or the debt markets.
Alternatively, income seekers could opt to depend on a unique feature of investment trusts. Unlike other types of collective investment vehicle, they are entitled to keep back some income in strong years to fund payouts to investors in leaner times. As a result, investment trusts find it easier to pay consistent levels of income – and to raise dividends regularly. Indeed, the Association of Investment Company’s (AIC) 17 “dividend hero” funds have raised their dividend every year for at least the past 20 years; some have records going back 50 years or more.
“During the pandemic this [income smoothing facility] really came to the fore, with 85% of equity income-paying investment companies maintaining or increasing their dividends in 2020, compared to just 23% of equivalent open-ended funds,” says Annabel Brodie-Smith, communications director of the AIC.
In practice, all the dividend heroes – and most investment trusts – pay income bi-annually or quarterly, but if you’re confident that payments will be consistent and reliable, it makes it easier to plan month by month.
One nuance to consider here is tax. In theory, income distributions from funds are subject to income tax (if above the dividend tax allowance and not held in a tax-efficient ISA or SIPP), while capital withdrawals could be exposed to capital gains tax, if you’ve made profits over the course of the tax year that exceed the capital gains tax threshold. This is currently £12,300, but the limit will fall to £6,000 in April and £3,000 a year later, in line with changes announced in last November’s Budget.
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It may be possible to manage your tax bill more efficiently given this distinction, by maximising capital withdrawals to minimise an income tax bill, for example. “You may be able to create a more tax-friendly source of income taking capital out rather than using income-only funds,” says Philippa Gee. “This means you can control the frequency and the amount, while still being able to pursue a wider range of investment options that reflect your objectives better.”
Alternatively, you can take tax out of the equation altogether by managing your investments inside an ISA, SIPP, or indeed both, income and profits on investments inside both accounts are tax-free; with respective annual contribution limits of £20,000 and £40,000. Therefore, over time you can move considerable sums inside these tax-free wrappers.
In summary, with monthly income funds, the bottom line is that there is a trade-off to make. For investors for whom the convenience of an automatic monthly payment trumps all else, monthly income funds can work really well.
For those who prefer to focus on maximising total return and securing diversification, it makes sense to cast the net more widely – and then to manage your returns to generate monthly income for yourself.
These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.
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