Why growth trusts belong in your retirement portfolio

by Helen Pridham from Money Observer |

We outline the strategies that retirees should consider beyond traditional income-focused trusts.

For many investors who have saved long and hard over the years to build up their retirement nest egg, whether within ISAs or SIPPs or outside, there is often a natural reluctance to start dipping regularly into capital to supplement a retirement income.

Switching to income-producing investment trusts in this situation appears to be a safer option. It means you can convert your returns into income and leave your capital untouched.

The only problem with this approach is that you are likely to end up restricting your choice to higher yielding trusts and potentially your portfolio's scope for future growth.

For this reason, it could be worth considering another strategy: using growth-oriented trusts and regularly cashing in some of your capital gains for income, or – possibly more acceptable to many people – constructing a portfolio which combines growth-oriented trusts with enough dividend-focused trusts to provide a minimum income.

Paying dividends out of capital growth

Nowadays, a third way is also available because there are some trusts which pay some or all of their dividends out of their capital profits.

One of the advantages of being prepared to take capital growth as part of your regular income is that it helps to add diversification to your portfolio.

Andy Merricks, head of investment at chartered financial planners Skerritts, has long been a fan of this approach. He says:

"I am all for using all the tools in the box to deliver income. In retirement, it is dangerous to concentrate on just one type of trust that you think will meet your needs. You need exposure to different asset classes."

Trusts focusing on income tend to invest in similar types of stocks, points out Merricks, adding: "If you are relying on dividends, it means you are also relying on the boards of the trusts to continue paying the same level of income. But the world is changing rapidly and things may happen which prevent them doing so."

His caution appears to be echoed by research carried out recently by Ben Lofthouse, manager of Henderson International Income Trust (LSE:HINT) and head of global equity income at Janus Henderson.

Investing in higher-yielding companies is not always straightforward, says Lofthouse. He warns of dividend "traps" – shares with yields that are too good to be true compared to similar companies or to the wider market. This can lead to cuts in dividends or a lack of sustainable growth.

Holding some income in reserve for tough times

Fortunately, many income-focused investment trusts hold income reserves which they have been able to build up during times when dividends are buoyant. They can use these reserves to support their own dividend payments if times get tough and some of the companies they hold in their portfolios are forced to cut back.

But if you spread your investment net wider, you could potentially gain greater control over your income by drawing down some capital growth too.

Merricks points out that if you need an annual yield of, say, 5% from your capital, you could invest in income-producing trusts to deliver 2.5%, and then you would only need your other holdings to produce growth of 2.5% to top up.

For Mick Gilligan, head of research at Killik & Co, taking out capital gains to provide a regular income stream has its pros and cons. On the plus side, he says: "It enables investors to gain exposure to areas which have an attractive long-term growth profile but do not normally provide an income, such as biotechnology. If you have holdings outside an ISA or SIPP it also means that you can 'top-slice' your gains and use your annual capital gains tax allowance (CGT) to take the money tax-free.

Which trusts?

However, he adds:

"Investors need to have the time and the inclination to manage this type of portfolio, and it is not ideal in a prolonged bear market because capital could be eroded." 

So how could you put such a portfolio together? For investors wanting to focus on income-paying trusts, there is a very useful tool now available on the Association of Investment Companies website, called Income Finder.

It enables you to create a virtual portfolio from a list of income-paying investment companies, which shows their yields and how often they make income payments.

You can track their dividend dates and see how much income you could receive over a year (based on current yields). It does not provide you with any suggestions about which trusts to include, but it enables you to experiment before you reach any decisions.

No-yield trusts with long-term capital gains

However, the list of trusts naturally does not include those without a yield, such as Baillie Gifford US Growth (LSE:USA) and Polar Capital Technology (LSE:PCT), which have been performing well recently. Six of Money Observer's own Rated Funds which are growth-oriented trusts are also omitted – Aberdeen New India (LSE:ANII), Allianz Technology Trust (LSE:ATT), Baillie Gifford Shin Nippon (LSE:BGS), Fidelity Japan Trust (LSE:FJV), Miton Global Opportunities (LSE:MIGO) and Pantheon International (LSE:PIN).

Also, though they are on the AIC Income Finder list, you may, as an income seeker, have traditionally shied away from total return trusts which aim for a combination of growth and income but have yields of less than 1%. Among our Rated Funds, there are eight such trusts – such as Baillie Gifford Japan (LSE:BGFD), Capital Gearing (LSE:CGT), JPMorgan US Smaller Companies (LSE:JUSC), Jupiter European Opportunities (LSE:JEO), Miton UK Microcap (LSE:MINI), Monks (LSE:MNKS), Scottish Mortgage (LSE:SMT) and Worldwide Healthcare (LSE:WWH).

Yet the long-term capital gains which may potentially be achieved by including some of these trusts in your portfolio could more than make up for their lack of dividends.

If you are going to have some growth-focused trusts in your portfolio from which you plan to take capital withdrawals, which will mean selling some of your shares, and you haven't already held them in your portfolio, you will need to give them a while to start growing.

For this reason, it is often a good idea to keep a tranche of cash in your portfolio to cover, say, your first one to three years of income, so you don't have to start drawing down investments immediately.

Another option, if you don't want the job of organising the capital withdrawals yourself, is to include some trusts in your portfolio which themselves use capital reserves to pay out income. These trusts can also give you exposure to sectors where yields otherwise tend to be low.

These include UK smaller companies, where yields are typically below 2%. One trust in this sector which uses capital profits to top up its income is Invesco Perpetual UK Smaller (LSE:IPU), which currently pays a yield of around 3.5%.

Other sectors include biotechnology and private equity, where trusts using capital to top up regular income payments include BB Healthcare (LSE:BBH), International Biotechnology (LSE:IBT), BMO Private Equity Trust (LSE:BPET) and Princess Private Equity (LSE:PEY).

Bear market risk

If you are holding trusts outside an ISA, taking capital gains in this way is not so attractive, as the dividends will be taxed as income (rather than being tax-free within your CGT allowance). There are also concerns about the risk of paying out regular amounts of capital if a trust falls in value or there is a prolonged bear market.

However, Killik's Gilligan points out that especially where income is paid quarterly, the effect on capital is smoothed out (rather like reverse pound cost-averaging). He also believes that boards "are very alive to the risk of eroding capital" and will be monitoring the effect of these payments.

Nothing is guaranteed in the stock market, but income investors who spread risk and incorporate a diversity of trusts in their portfolios will almost certainly be rewarded in the long run.

The trusts that use capital to pay their dividends

An easy way of using capital to supplement your income is to choose investment trusts that do it for you. Since 2012, a change in the tax laws has given investment trusts the ability to pay dividends wholly or partly out of capital. Boards which want to pursue this course of action must seek the consent of their shareholders in order to do so.

Aberdeen Japan (LSE:AJIT), for example, recently sought approval at its AGM to use capital reserves to top up its earnings and provide higher, sustainable dividends.

Taking the power to use their capital reserves to fund dividends does not mean trusts will actually do so. Although some trusts, such as European Assets, International Biotechnology (LSE:IBT) and Princess Private Equity (LSE:PEY), are now paying their dividends mainly out of capital, others, such as Invesco Perp Select UK Equity (LSE:IVPU) and Securities Trust of Scotland (LSE:STS), are using it as a backstop.

In a recent report, Rachel Beagles, chairman of Securities Trust of Scotland, explained its approach. "It is the board's intention to deliver a progressive dividend policy, using its retained capital profits if necessary.

The board believes that this policy allows the manager to focus on maximising the long-run total return in the portfolio, by allowing more flexibility to hold stocks in the portfolio with greater growth characteristics, albeit with sometimes slightly lower yields." 

In July 2018, 15% of the trust's quarterly dividend was paid from capital – the first time that this policy had been put to use since the policy was announced in May 2015.

Unfortunately, finding out which trusts have taken the power to pay dividends from capital reserves is not easy, especially when the companies are using a hybrid approach.

Annual reports are not always clear on the issue either. BMO UK High Income (LSE:BHI) states clearly that its aim is to provide "an attractive return…in the form of dividends and/or capital repayments".

But it is hard to find any mention in RIT Capital Partners (LSE:RCP) annual report that its dividends are paid mainly out of capital, though this may be inferred from its stated investment objective of solely "long term capital growth".

Trusts paying income from capital

Investment Company Dividend frequency Yield (%)*
Aberdeen Emerging Markets (LSE:AEMC) Qrtly 3.65
Alternative Liquidity Fund (LSE:ALF) Semi-An n/a
Baring Emerging Europe (LSE:BEE) Annual 4.2
BB Healthcare (LSE:BBH) Semi-An 2.92
BMO Private Equity Trust (LSE:BPET) Qrtly 4.42
BMO UK High Income (LSE:BHI) Qrtly 5.45
Civitas Social Housing (LSE:CSH) Qrtly 6.79
Dunedin Enterprise (LSE:DNE) Semi-An 14.2
Electra Private Equity (LSE:ELTA) Semi-An n/a
European Assets (LSE:EAT) Qrtly 5.55
Impact Healthcare REIT (LSE:IHR) Qrtly 5.37
International Biotechnology (LSE:IBT) Qrtly 4.52
Invesco Perp Select UK (LSE:IVPU) Qrtly 3.82
Invesco Perpetual UK Smaller (LSE:IPU) Qrtly 3.54
JPMorgan Asian (LSE:JAI) Qrtly 4.37
JPMorgan Global Growth & Income (LSE:JPGI) Qrtly 3.80
Martin Currie Asia Unconstrained (LSE:MCP) Semi-An 4.00
Personal Assets (LSE:PNL) Qrtly 1.30
Princess Private Equity (LSE:PEY) Semi-An 5.84
RIT Capital Partners (LSE:RCP) Semi-An 1.64
Securities Trust of Scotland (LSE:STS) Qrtly 3.30
Standard Life Private Equity (LSE:SLPE) Qrtly 3.6
Tritax Big Box (LSE:BBOX) Qrtly 4.56

Notes: *Yields as at 19 June. Source: AIC/Morningstar, Money Observer research

This article was originally published in our sister magazine Money Observer. Click here to subscribe.

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.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.

get more news and expert articles direct to your inbox
Sign up for a free research account and get the latest news and discussion, and create your own Virtual Portfolio