InvestmentsNov 17 2014

Why investment trusts could benefit from pension freedoms

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Investors are often referred to as being on the ‘hunt for income’ and with pension reforms on the horizon and the ongoing low interest rate environment, it would seem the hunt is still on.

The government’s pension shake-up means that those reaching retirement age will no longer be required to buy an annuity from next year, so many will be encouraged to seek other means of providing income while remaining invested in retirement.

The case for trusts

Investment trusts have long been lauded as income generators, as the Association of Investment Companies (AIC) verifies. Their ability to generate income through most market environments is a key feature of their growing appeal - albeit from a relatively low base in the intermediary channel.

Jemma Jackson, PR manager at the AIC, suggests: “The investment company sector has a well-earned reputation when it comes to income generation.

“The AIC publishes a list of investment company ‘dividend heroes’ each year: companies which have been able to increase their dividend each year through both the good times and the bad, through booms and bust. And while this is never guaranteed, it is nevertheless a reassuring feature for many investors.”

She notes that there are around 20 investment companies that have been increasing their dividends each year for more than 20, 30 and, in some cases, 40 years. There are countless more that have been notching up annual dividend increases for 10 years and counting, she adds.

The AIC recently published figures which show that the investment company UK Equity Income sector dividend increases beat inflation by more than 2 per cent a year over a period of 20 years.

Its figures revealed that £100,000 invested in the average UK Equity Income investment trust on September 1 1994 had generated an initial annual income of £3,265 by August 31 1995. This annual income would have climbed to an impressive £8,139 by August 31 this year.

This means that the annual income grew by an average of 5 per cent per year over 20 years, while inflation (RPI) averaged 2.9 per cent over the same period. Ian Sayers, director general of the AIC, believes that these figures make the case for investing in investment trusts at retirement.

He comments: “Of course, this type of investment is very different from buying an annuity. There are no guarantees and you are putting both your income and capital at risk. But for those who can accept the risks, these figures make a compelling case for investment companies to be considered as part of a long-term income portfolio.”

Protecting dividends

In terms of how trusts go about ‘protecting’ their dividend, Ms Jackson explains: “They can do this by squirreling away some of the income they receive each year and saving it for tougher times – such as dividend cuts from portfolio holdings – BP’s oil spill, which led to a dividend suspension, being a case in point.

“This is a unique characteristic which sets investment companies apart from other forms of collective investment.”

James Pigott, managing director of Pigotts Investments, agrees: “Income is an important part of any portfolio, either simply to pay fees or better still for reinvestment. Investment trusts can provide a good income flow. Nothing is guaranteed but with many trusts producing an increased dividend each year for more than 40 years, the case is clear.”

He adds: “This is crucial for income seekers as it means that there is a good chance your income could grow with, or ahead of, inflation.”

More recently, some trusts have sought shareholder approval to dip into capital to cover dividends. While this feature is yet to be utilised fully by the investment trust sector, it is worth noting that this can be done.

Mr Pigott adds that although these types of investment vehicles do not expect to have to use this feature, it does act as an additional “safety net”.

Illiquid options

The UK Equity Income sector is not the only investment trust sector to have delivered a growing income over the years.

As Ms Jackson points out: “Some of the highest yielding investment companies are in the alternative assets space, such as Sector Specialist: Infrastructure, Sector Specialist: Debt and the property sectors. Such areas have been a real growth area in recent years, responding to the huge demand for yield.”

She notes that investment trusts are well placed to invest in illiquid assets because managers do not have to sell stock to meet redemptions.

“The flip side, however, is that such is the demand for many of these specialist investment companies that many are trading on premiums, with some regularly issuing shares in an effort to help keep up with demand,” she cautions.

“So valuations are worth watching carefully, although an adviser I spoke with recently was sanguine about the premium on one of the infrastructure companies because he said there was ‘no other fund like it’,” Ms Jackson recalls.

“Of course, advisers will have their own views on premiums and whether they are willing to buy companies at a premium and it has to be taken very much on a case-by-case basis.”

Long-term value

Over the years, investment trusts have proved they are a reliable source of income, so should investors be considering these vehicles as part of their long-term portfolio?

“They certainly should do,” says Mr Pigott. “With the changes to the tax on passing on a pension to dependants, pensions have the potential to be used to minimise inheritance tax (IHT). This now contradicts the initial thought people had of busting their pensions.

“So assuming we are now looking at more being ploughed into pensions, they suit long-term investment very well and should be able to outperform, especially with a little gearing.”

He advises: “Also there are some good investment trusts which are based offshore, such as Guernsey or Jersey, that produce a gross dividend and if held in a self-invested personal pension (Sipp) or Isa there will be no tax to pay.”

For those investors who are not already invested in investment trusts, the changes to pensions may prompt them to dip a toe into this type of vehicle, while those already familiar with trusts may be reassured of their continued ability to deliver income.

Eleanor Duncan is deputy features editor at Investment Adviser

eleanor.duncan@ft.com