Portfolio Dilemma: should I focus on funds paying a monthly income?

Name withheld asks: I’m weighing up my options ahead of retirement. My portfolio consists of growth-focused funds and shares, but I’m considering a change in approach and giving the portfolio more of an income focus. I like the idea of trying to withdraw only the income generated from the investments each month, but I’m not sure how feasible this is. I’m planning to hold both income funds and some FTSE 100 dividend-paying shares. For funds, should I just focus on those that pay a monthly income to make life easier?

Investors looking for regular income have far more choice nowadays. More than 100 funds now pay monthly distributions, compared with only a few dozen 15 years ago.

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The approach is convenient as such funds automatically generate a stream of cash that will be paid out each month. However, I would urge investors to view the regularity of the income payments as a “nice to have” rather than a must-have.

Instead, prioritise whether the way in which the fund invests (its asset allocation) meets your risk profile and objectives. In addition, size up the fund’s track record and consider the expertise of the management team, including how long they’ve been running money. If a fund falls short on these measures, its monthly payout schedule alone shouldn’t be enough to earn it a place in your portfolio.

For me, it doesn’t make sense to rule out funds or investment trusts that pay quarterly, or even half yearly. With a little planning, investors can create a monthly income stream by combining funds and trusts that make distributions at different points throughout the year.

In addition, going solely down the income fund route can increase risk and reduce diversification as fund managers are restricted to owning a range of stocks or bonds to deliver on their objectives.

One way to create a more diversified retirement portfolio is to take a total return approach. Instead of relying only on dividends and interest for income, withdrawals can be funded from the portfolio’s overall returns.

For example, an investor aiming for £1,000 a month doesn’t need all the investments to pay £1,000 a month in income. A portfolio generating £700 in dividends and interest could be topped up through regular capital withdrawals, potentially giving you access to a broader range of investments.

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Another thing to bear in mind is the shortage of options for investors on the lookout for monthly income funds that focus solely on equities. Most monthly income funds invest in bonds or adopt a multi-asset approach (shares and bonds).

For bond funds that pay a monthly income, there’s a tendency to focus on high-yield bonds, which carry greater risks than high-quality bonds, such as UK gilts.

That being said, multi-asset funds throwing off regular income are potential core holdings for retirement portfolios. Below are some of the options, although as mentioned, it is important to judge the fund on its merits.

For investors set on receiving monthly distributions, the following funds may be worth further research.

Those that pay out monthly and hold between 20% and 60% in shares include abrdn Diversified Growth and Inc I Inc (B1C4288) (yield of 4.4%); Artemis Monthly Distribution I Inc (B6TK3R0) (yield of 3.7%); Invesco Distribution UK Z Inc (B8N4543) (yield of 4.4%); Premier Miton Cau Mthly Inc B Inc units (B79QBF9) (yield of 4.9%); and Schroder Monthly Income Z Inc (B66FVB8) (5.6%).

Funds that invest solely in UK shares and pay a monthly income include AXA Framlington UK Equity Income Z Inc (B8HHY29) (yield of 3.9%); Fidelity Enhanced Income W Inc (B87HPZ9) (yield of 6.9%); and Man Income Professional Inc D (B0117D3) (yield of 4.1%).

Yield figures, provided by Morningstar, reflect the 12-month average.

How do monthly income funds work?

The fund manager invests in shares, bonds, or a mix of the two. The amount of income generated is based on the dividends the underlying holdings have paid each month.

Therefore, as with any fund, the income can vary, but to counteract this most of the funds smooth the dividend payments into 11 equal amounts, followed by a final payment of everything that’s left over.

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Investors need to select the “income (inc)” share class to receive the cash each month into their account. A fund’s factsheet will contain the income payment dates and the past dividends per share. 

Investment trusts vs funds for regular income

As seasoned investors can testify, the investment trust structure can work very well for investors looking for a regular income stream.

This is because one of the advantages of investment trusts is their ability to squirrel away income for a rainy day. Up to 15% of income generated each year from underlying investments can be saved, in what is called revenue reserves.

When there’s a period where the income from underlying investments dries up, for example during the Covid-19 pandemic and the financial crisis, investment trust boards can utilise those reserves and top up shortfalls. 

This is why there are an impressive number of investment trusts that have raised their dividends year in, year out, for long periods, with 20 increasing their dividends for more than 20 years. 

In contrast, open-ended funds don’t have the same option when there’s a lean income period. Funds are required to return all the income generated to investors. Therefore, if the underlying investments held by the fund are making less money, less income will be paid to investors.