Picking the right income funds

While those in the retirement markets have been frantically innovating, several in the investment space have simply pushed existing products, in the hope that their funds designed to provide an income can provide a solution to fund individuals’ retirement.

As soon as the freedoms were announced, concerns were voiced about whether people would frivolously fritter their entire pot on some expendable luxury. In reality of course, that is not likely. Those who have been responsible enough to save throughout their working life, are probably not going to suddenly become rash enough to blow the lot on impulse once they reach retirement. Anyone who does decide to take their pot is almost certainly going to choose to invest it, or at least some of it.

The logical place to do so will be in an income fund, whether closed- or open-ended.

As mentioned, several investment houses have been keen to elbow their way into the space. Big names in the fund management universe have hosted and attended a series of panels and debates on the subject, eager to present themselves as authorities and ensure their names are associated with retirement planning.

Other companies have launched new products, marketed to capitalise on the new rules. Threadneedle was among the first of these; as early as July last year, just four months after the budget, it unveiled a multi-asset fund, positioned from the outset as a retirement income solution.

The Global Multi-asset Income fund uses an active asset allocation to target high income with a relatively low volatility. Threadneedle did already offer a range of income funds, notably the UK Equity Income and Global Equity Income funds.

According to Toby Nangle, the group’s head of multi-asset, Threadneedle ran several simulations to examine how equity-focused funds would perform versus a multi-asset fund built to deliver comparable levels of total return while limiting downside volatility. These simulations ultimately led to the launch of the new fund.

Mr Nangle adds that the pensions industry has been slow to exploit the new rules’ possibilities, “The defined contribution landscape is still really trying to consider how it responds to the new pension freedoms.” He argues that many lifecycle default schemes are designed to ‘smooth’ savers into an annuity purchase but, “Schemes don’t seem to have quite yet decided how to redesign and what they smooth into, so we wanted to make this fund something that could be used by default DC schemes. As such we brought it in in a way that would allow it to be used within the new charge cap.”

This cap, limiting charges on AE default funds to 75 basis points, will prevent most retail income funds from attracting the masses, but there is nothing to stop sophisticated investors from taking their entire pot and using it to build an income-paying portfolio.

We decided to take a look at how well-equipped income funds would have been to fund a hypothetical retirement.

The Table shows the best performing income-paying funds based on an initial investment of £250,000, drawing £2,000 per month. Using data up to 1 March, the results show performance over five, 10, 15 and 20 years for both open and closed-ended vehicles.

The most common fear – of money running out as drawdown becomes more prevalent – may yet prove well-founded for those with smaller pots. Our figures admittedly use a much larger initial pot than the average pensioner will enjoy, but for wealthier retirees the top-performing existing income funds look well positioned to mitigate this risk.

However, the top performers may give a distorted view. Over five years the unit trust space is healthy. 240 of 875 funds have actually increased their value despite the regular withdrawals. The average has only dropped to £229,908. But longer time periods become riskier. Three funds would have seen the pot expire over 10 years, despite the total income over that period being £10,000 less than the initial pot value.

Over 15 years, more than four-fifths of funds would have run out of cash. While the 20-year period is more forgiving, 95 of 273 funds would have run out. And one of the remainder would be unable to meet the next payment.

The difference between starting the fund in time to capture the growth of the late 1990s and starting in time for the dotcom bubble bursting is stark and highlights the widely discussed difficulty in timing drawdown.

What is striking is, while several of the top performers come from more exotic spaces, mainstream sectors such as UK All Companies provide top performers, especially over the long term.

Annabel Brodie-Smith, communications director at the AIC, talks of the structural advantages that make investment companies suited to income, predominantly the ability to retain some of the income from their investments – up to 15 per cent each year – which allows them to increase dividend payments.

Also, as companies, investment trusts can generate their own dividends, meaning they can pay income out of capital profits rather than relying on share dividends.

Investment trusts do provide better performance at the top end. The best performer over 20 years would now be worth 10 times the initial value with an AGR of 33.6 per cent. Obviously very few will hold their entire pension pot in one investment trust and, if they did, Emerging Europe is unlikely to be the destination of choice, but the figures show what can be done.

However, investment trusts are more prone to running out of cash than their open-ended counterparts. Three would have seen the entire pot spent within five years. Ms Brodie-Smith is at pains to point out that, while investment trusts are equipped to contribute to retirement, they are “not a substitute for an annuity and should be part of a well balanced portfolio.”

The same is true of unit trusts. Most importantly, that portfolio will need to be actively monitored if retirees are going to reap the potential and avoid the downside.

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