Investor’s Guide to Income
The need for income remains firmly at the top of the investor’s New Year priority list and as the hunt for high yield opportunities continues, being able to understand and compare the numerous options available is becoming more important than ever. So what better place to start 2015 than with our first Investor’s Guide of the year where we give you an overview of range of income options on offer, as well as compare some of our most popular investment ideas from last year and their main differences.
Why is income a top priority?
There’s no denying that generating an income is one the most common demands placed on our capital, even more so as low interest rates appear to be with us for some time to come and there remains an inevitable uncertainty around what might happen to inflation in the coming years. Whilst annuity rates also remain low and many salaries and retirement incomes fail to keep up with the real cost of living, it is understandable why income remains a top priority, regardless of our stage in life.
Trends from 2014 show that there were record numbers of ISA savers using the investment element of the New ISA allowance, revealing that many of us are having to take on more risk than before in an attempt to try and produce the levels of income previously enjoyed. So as we embark on 2015, this brief investor’s guide to income is the start of an income theme that that will continue to develop as pension freedom rules bring further income considerations later in the year and ISA savings take on an increasingly important role. So what are the main areas for consideration?
Open ended or fixed term?
Most investors who have had income investments in the past are likely to have at least considered an open ended investment fund. Here, your investment is pooled together with those of other investors which combine to make a single fund. Your investment buys units in that fund at the prevailing price, which is normally priced daily based on the value of the underlying holdings. The majority of income funds are actively managed which means that an investment manager, often supported by a team of analysts, researches companies and then invests accordingly, moving in and out of companies depending on their view of where income, and perhaps growth, can be obtained and in line with fund’s investment objective.
Since there is an ongoing management of the fund, there is normally an annual fund management charge along with additional charges for the platform and/or service within which you hold the fund. Open ended funds, as the name suggests, are designed to carry on regardless of whether new investors buy in, or existing investors sell their investment. The investor is therefore in control of when you buy the units in the fund as well as when you decide to sell them, the price of which can go up and down on a daily basis depending on where the fund is invested and the performance of those assets.
Fixed term investments on the other hand last for a defined term, known at outset, and is normally around five or six years. Although most of these investment plans offer a daily secondary market price, which can be higher or lower than the price at the start the plan (and in this respect not dissimilar to investment funds), these investments are designed to be held for the full term. The fixed term may appeal to those who wish to plan around this and it also removes what can often be the difficult decision of when to sell or switch your existing investments.
Fixed income versus variable income
Income funds can be broadly split between two types, both of which offer variable income which means it can go down as well as up. Firstly, those funds which invest in companies (shares) and use dividends to provide income, for example funds in the UK Equity Income sector. One such fund and one of the most eagerly anticipated fund launches in recent times was the first fund offered by Neil Woodford’s new venture, the CF Woodford Equity Income fund, which targets a 4% income yield each year with quarterly payments.
The second type are those funds which use bonds and/or gilts to provide income, such as Royal London’s Corporate Bond fund. This fund is Gold rated by Morningstar OBSR and has a current distribution yield of 4.84% with quarterly income payments. Since the market value of both types of funds can fall as well as rise over time, so can the value of your units and since the fund manager will buy and sell different company shares or bonds depending on their view of the market, so too does your income vary.
Investment plans on the other hand can offer either variable income or fixed income. One popular example of a variable income is the Income Accumulator Plan from Morgan Stanley, which offers up to 6.75% each year with income being accrued for each week the FTSE 100 Index closes between 5,000 and 8,000 points – if it closes outside of this range, no income will be added for that week. All accrued income is then paid out to you at the end of each quarter.
With fixed income investment plans you know exactly what you will be paid, when and for how long, which has its obvious appeal for those looking to plan for the future and are seeking a regular and defined income. The Enhanced Income Plan from Investec was our most popular income investment during 2014 with the current issue paying 5.28% annual income regardless of what happens to the stock market and against. Since most yields on income investments are variable this is a distinct difference which in the current climate could make for an attractive income alternative.
Monthly or quarterly payments?
Another important feature of income investments is how often income is paid out. The most common payment frequencies are bi-annually, quarterly and monthly, with the more regular frequencies usually being the most popular. These investments therefore provide a regular opportunity to receive an income although different investment funds have different payment frequencies with many bond funds offering monthly income, whilst equity funds normally pay quarterly and sometimes twice yearly.
Investment plans normally offer monthly or quarterly payments. The Enhanced Income Plan mentioned above offers a monthly payment, currently at 0.44% of your initial investment, and since monthly income can be the most useful in terms of budgeting and is attractive when looking to supplement existing income, this payment and frequency stands out when compared with most equity income funds which offer either quarterly or twice yearly payments. The Income Accumulator Plan pays out any accrued income at the end of each quarter.
Conditional capital protection versus diversification
Investment plans include what is known as conditional capital protection. This means that your initial capital is returned at the end of the investment term, as long as the underlying investment (for example, the FTSE 100 Index) has not fallen below a fixed percentage of its value at the start of the plan, normally 50%. This therefore offers some capital protection against a falling stock market. Your capital will be at risk if the underlying investment does fall below the defined level, in which case your initial capital will be reduced by 1% for each 1% fall, so there is the chance you could lose some or all of your initial investment.
Your capital in an investment fund is at risk based on the value of the underlying holdings, which can go up or down on a daily basis. As such, there is no capital protection offered, nor is there the conditional capital protection associated with fixed term investment plans. However, since most funds invest in multiple holdings (equity funds between 30 and 90, bond funds often over 100), the impact of one of the underlying holdings falling significantly in value is reduced – this is commonly known as diversification. Investment funds also have the opportunity for capital growth should the value of the underlying investment rise in value, a feature which is not usually available within income investment plans.
Unlike a fund, fixed term investment plans use your investment to purchase securities issued by the counterparty, usually a retail or private bank, which means that their ability to meet financial obligations becomes an important investment consideration. This is known as credit risk and means that in the event of the bank’s insolvency, you could lose some or all of your initial capital as well as any rights to future income and these investments are not covered by the Financial Services Compensation Scheme for default alone. There are various global credit rating agencies which assist in determining the potential credit worthiness of these institutions.
Risk versus reward
When considering income investment options it is important to understand the principle of risk versus reward, which means that the opportunity to receive a higher income than might be available from cash deposits inevitably requires the investor to put their capital at risk. A good benchmark for assessing your investment is to compare what you could get from a fixed rate deposit over a similar timeframe and then consider whether you are comfortable with the additional risk you are taking in order to receive either a high fixed return or the potential for a higher variable income.
Leading five year fixed rates are currently offering around 3% and so by accepting risk to your capital, the potential income over and above this along with the potential for capital growth where relevant, allows the income investor to decide whether they are comfortable with putting their capital at risk in return for the yields on offer. Any conditional capital protection should also be a consideration, as should the potential to protect your income from the effects of inflation over time.
Use your New ISA allowance for tax free income
By contrast to the interest rate environment, there was some better news last year as the Budget brought about the most significant changes to ISA rules since their introduction in 1999. Since 1st July 2014, not only does has the overall ISA allowance increased to £15,000 per tax year, but importantly the distinction between Cash ISAs and Investment ISAs (or Stocks & Shares ISAs) has been removed since you can now place up to the full allowance in one or a mixture of both – it will be up to you how much of this you put into cash and investments.
One of the main benefits of an ISA is that income is received tax free and with no further tax to pay. This is particularly attractive for income that would normally be subject to income tax (interest from deposit based savings, most investment plans and income from bond funds) where the impact of tax can be significant, especially over time. With the lowest marginal rate of income tax currently standing at 20%, this is a sizeable reduction to any stated returns on offer. Remember that tax treatment of ISAs depends on your individual circumstances and may be subject to change in the future.
Fair Investment conclusion
Commenting on the range of income investments available, head of savings and investments at Fair Investment Company, Oliver Roylance-Smith, said: “Investment funds have traditionally been the more popular choice for income investors with varying investment objectives and a wide range of underlying investment styles and sectors to choose from. These also bring with them diversification benefits of spreading your investment across a number of different companies or bonds, as well as the potential for capital growth in addition to a regular income stream.”
He continued: “As an alternative to open ended investment funds, the defined return and defined risk offered by fixed term investments offer investors a different approach to achieving income. Their conditional capital protection also means that your initial investment has some protection against a falling market. Combined with either a fixed or variable income and these plans can offer a competitive balance of risk versus reward that could be considered by both savers and investors.
Whichever route your choose, the market for income investments can be full of attractive headline yields but it is important to fully understand how each investment works and the risks it entails. Whether this is inflation risk, risk of capital loss or fluctuating yields, it should always be remembered that it is the income and capital loss/rise combined that produce your overall return.”
We have a number of fixed term investment plans which offer either a fixed income or a variable income based on the performance of the underlying investment.
Click here to compare our current selection of income investment plans »
Fair Investment Fund Supermarket
With over 2,100 funds from over 95 investment managers, the Fair Investment Fund Supermarket offers a vast choice of income funds, many of which have 0% initial charge as well as a discount on annual management charges of up to 0.2%.
Click here to find out more about the Fair Investment Fund Supermarket »
No news, feature article or comment should be seen as a personal recommendation to invest. Prior to making any decision to invest, you should ensure that you are familiar with the risks associated with a particular investment. If you are at all unsure of the suitability of a particular investment, both in respect of its objectives and its risk profile, you should seek independent financial advice. Tax treatment depends on your individual circumstances and may change and may be subject to change in the future.
Structured investment plans are not capital protected and are not covered by the Financial Services Compensation Scheme (FSCS) for default alone. There is a risk of losing some or all of your initial investment. There is a risk that the company backing the plan or any company associated with the plan may be unable to repay your initial investment and any returns stated. In addition, you may not get back the full amount of your initial investment if the plan is not held for the full term. The past performance of the FTSE 100 Index and any of its shares is not a guide to its future performance.