We explain how you can build your own portfolio to provide regular income.
Since the pension freedoms were introduced nearly eight years ago, it has become increasingly common for individuals to use their pension to pay themselves an income at retirement.
For most, the aim will be to secure a reliable and regular income from their investments, with the intention of not inflicting too much harm on the capital.
The good news is that for those who arrange their investments carefully, a monthly income can be achieved. There are several ways to go about this, as we explain below.
Doing the sums
First some groundwork needs to be done. To calculate how much income you need to generate factor in the state pension (if you are at an age where you can claim it), as well as any other assets that can be drawn on in retirement, such as ISAs, and for those who have them defined benefit pensions.
Once you've done all those sums, you can work out the size of your income gap, which will determine the return you need to generate.
It could be the case that your pot size is too small to achieve the target you have in mind, or that it requires stomaching a higher amount of risk than you are comfortable with.
For example, to generate income of £20,000 a year, a pot size of £400,000 would require an investment return of 5%. For larger sums, the dividend yield target would be lower, 4.5% for £450,000 and 4% for £500,000.
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Generate the natural income
There are various ways to arrange investments to pay an income at retirement, with the most obvious being to focus primarily on income-generating assets.
To reduce risk, which is particularly important in retirement, one approach is to draw only the income produced by the underlying investments held by professionally managed funds and investment trusts (the ‘natural yield’), rather than eating into capital growth.
This is because, under a scenario where stock markets fall sharply and income withdrawals are maintained or increased during that period, it is difficult for a retirement fund’s capital value to recover afterwards.
That’s particularly the case if you’re drawing on capital to maintain the required level of income when the market falls (as opposed to taking only the ‘natural’ yield), as reducing the number of fund units you own makes it much harder for the fund to regain value.
For those who continue to draw income from a pension pot at that stage, a vicious cycle is created, resulting in the number of units and value of investments reducing further. In the worst-case scenario, this potentially means the pension pot running out before you die.
The phenomenon is known as pound-cost ravaging, which is the inverse of pound-cost averaging.
Monthly income funds
The hassle-free route is to focus solely on funds paying a monthly income. A decade ago there were only around a couple of dozen funds paying monthly, but now there’s more than 150.
The downside is that there’s only a small number of funds that solely invest in equities. Most monthly income funds invest in bonds or adopt a multi-asset approach. The latter invest in both shares and bonds.
Bear in mind that some of these monthly income funds invest solely or have big weightings to high-yield bonds, which is the risker end of the fixed-income universe.
With monthly income funds, the amount of income generated is based on the dividends or coupons 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 12 equal amounts, holding back some income in good months, which is then used to top up leaner periods. Any excess cash leftover at the end of the year is then handed back to investors.
Four of interactive investor’s Super 60 investment ideas return income to investors monthly: Man GLG Income, Fidelity Multi-Asset Income, Balanced Commercial Property (LSE:BCPT) and Artemis Monthly Distribution.
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Man GLG Income, which has a yield of 5%, invests in UK stocks that have above average dividend yields.
Fidelity Multi-Asset Income owns third-party funds. It yields 4.8%.
Balanced Commercial Property yields 5.8%. It invests in a range of property assets, from industrial buildings such as warehouses, to offices and shopping centres.
Artemis Monthly Distribution, a multi-asset fund, invests around 60% in bonds and 40% in shares, and has a yield of 4.8%.
Mix growth and income strategies
The good news for income seekers is that a balanced portfolio containing a mix of shares and bonds will have a higher yield than a year ago. This is because bond prices have fallen notably due to rises in interest rates. However, for investors buying today the silver lining is that the income generated by bonds is at its highest and most attractive level in around a decade. Therefore, it is much easier to generate a decent level of income from shares and bonds.
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However, it is prudent to not bet the house on income strategies. Given that average life expectancies are in the mid-80s, a pension portfolio also needs exposure to growth-producing assets to strike an appropriate balance.
Having exposure to growth strategies will also help to give your portfolio greater diversification. It will also allow the flexibility of less exposure to bonds, assuming you can tolerate the higher volatility associated with shares.
Most income funds tend to aim to generate capital growth, as well as income. However, some put most focus on income generation. As ever, it is a case of looking under the bonnet to find out which approach is being taken.
City of London (LSE:CTY) investment trust, a member of interactive investor’s Super 60, aims to provide long-term growth in income and capital by mainly buying FTSE 100 companies. It has a yield of 4.7%, and has raised its dividend for 56 consecutive years.
Dividend calendar trick
One strategy for a mix of growth and income is to consider exposure to ‘dividend hero’ investment trusts that have long track records for growing their dividends year in, year out.
Most investment trusts, as well as funds, pay income quarterly these days. Although some continue to pay twice a year. Therefore, to achieve a monthly income, the dividend hero trusts selected will need to pay dividends at different times of the year.
Eight investment trust dividend heroes boast more than 50 years of consecutive increases. They are: City of London, Bankers (LSE:BNKR), Alliance Trust (LSE:ATST), Caledonia Investments (LSE:CLDN), The Global Smaller Companies Trust (LSE:GSCT), F&C Investment Trust (LSE:FCIT), Brunner (LSE:BUT), and JPMorgan Claverhouse (LSE:JCH).
Bear in mind that for some dividend heroes the dividend yields are fairly low, which is a reflection of the trusts’ broad emphasis on growing the capital and raising the payout, rather than offering a high level of income.
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Investment companies’ ability to hold back up to 15% of the income they receive each year in a revenue reserve gives them an advantage in delivering consistent income to investors over funds. In contrast, funds have to distribute all the income generated by the underlying investments each year.
The investment trust structure came into its own during the global financial crisis and again during the Covid-19 pandemic. Boards dipped into their reserves to top up income shortfalls from underlying investments so that they could maintain their long track records of raising their dividend year in, year out.
Don’t overthink how regularly income is paid
However, there’s plenty of logic in not overthinking how frequently dividends are paid.
Selecting funds or trusts just because they pay income out in a particular month should not be the main reason you buy.
Given that most funds and trusts pay quarterly or twice a year, you could manually spread the income produced into regular payments throughout the year. By not focusing solely on when dividends are paid, or monthly income funds, there is a much bigger pool to fish in.
All-out income attack
For those who are happy to prioritise income and looking for a high income of over 5% , there are fewer options, and they are more adventurous.
For equities you could consider the small number of funds that artificially boost their dividend yields through using a special technique that involves selling derivatives to other investors to boost the income. Under this strategy, the fund manager agrees to share any future capital gains with a third party. A fee is paid for the agreement which creates immediate, up front income. This can be distributed to unit-holders in the fund as a stream of income.
The downside is that, if the fund's holdings rise in value, some of that gain goes to whoever bought the derivative. Therefore, such funds lag the pack in rising markets.
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But as the buyer has paid up front, the risk of not being able to deliver a chunk of extra income is limited.
For bonds, it is the riskier end of the market that offers the highest income: high-yield corporate bonds and emerging market debt. Super 60 funds Royal London Sterling Extra Yield Bond and M&G Emerging Markets Bond are yielding 6.6% and 6%, according to FE fundinfo.
Elsewhere, some property and infrastructure funds and investment trusts offer yields above 5%. Examples include Balanced Commercial Property (LSE:BCPT), yielding 5.8%, and the average renewable energy infrastructure investment trust has a 5.5% yield.
How to reduce the risk of an income shortfall
Turbulent times for stock markets over the past year serve as a reminder to investors of the challenge of paying yourself an income and attempting to keep capital intact.
As mentioned at the start of the article, taking only the ‘natural yield’ is considered a prudent way to reduce risk during turbulent times.
Another tactic is for an income-producing retirement portfolio to have a separate cash pot, which can be utilised during lean periods. This cash pot ideally has a year or two years’ worth of spending ready in cash. This gives you the flexibility to postpone drawing income to give your investments a chance to recover.
This cash could be held in a money market fund, which invests in safe bonds that are due to mature soon, meaning that investors can get a modest income without taking much investment risk.
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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