Forget cowardly annuities and turn to the ‘dividend Heroes’

The L&G speaker ran through some worked examples of how much you would have to save in order to buy an annuity giving you two thirds of your final salary. As someone who is trying not to think of himself as middle-aged, but finding that increasingly difficult, I found this pretty terrifying.

As I listened, the prospect of that round-the-world cruise seemed to float off into the sunset.

The speaker’s conclusion was that for many of us, an annuity will no longer be how we finance our retirement. That conclusion carries more weight when you consider it is coming from a company that sells annuities.

In the rush to cook up and promote new products to solve this retirement income quandary, there is a danger that one established product will be overlooked. Investment companies have been around for nearly 150 years, and a good number of them have provided unbroken runs of income growth for multi-decade periods.@Image-95174136-094d-43a8-a8f4-597a6b033c28@

I wish I could say this was purely down to the skill and wisdom of those in the investment company industry. But in reality, it is also thanks to the ability of investment companies to reserve up to 15 per cent of the income made in any one year to pay out in future. Judicious use of this ‘revenue reserve’ has enabled UK and global investment companies such as City of London, Bankers, Foreign & Colonial and Witan to grow dividends for more than 40 years in a row, never once holding or cutting them, through all sorts of upheavals and varying market environments.

Typically, these ‘dividend heroes’ have enough reserves to pay out income for around one year, even if they received no income at all from their portfolio. That could cushion the blow of the dividend cuts many fear from FTSE titans. With UK payout ratios looking stretched, the dividend heroes are poised to draw on their reserves and defend their hard-won records.

Investment companies have a few other tricks up their sleeve when it comes to income. They can pay dividends out of capital profits, enabling non income-generating asset classes such as private equity to provide a dividend stream. They can also invest in a far wider range of income-producing assets than an open-ended investment company or unit trust could.

Investment companies can invest in a far wider range of income-producing assets than an Oeic or unit trust

Take infrastructure, for example. Though there are open-ended infrastructure funds, they cannot invest directly in infrastructure projects, which are too illiquid. But infrastructure investment companies can directly access the stream of government-backed, inflation-linked payments from a contract to operate a road, bridge, school or hospital. If you are looking for income that is not correlated to equity markets, this fits the bill. The track record here is much shorter, admittedly, than those of the dividend heroes. But in the 10 years the asset class has been around, income has been very stable.

Slightly more mainstream are commercial property investment companies, some structured as real estate investment trusts. Open-ended funds can, and do, invest in physical property, but the limitations to this approach were laid bare in the financial crisis, when several open-ended funds had to close to redemptions in order to protect their portfolios to what would otherwise have been mass outflows. Much more recently, several large property funds have moved to bid pricing to discourage outflows.

Investment companies that invest in property do not have to manage inflows and outflows. They can be fully invested, without any need to hold a cash ‘buffer’, a factor that can hold back returns from open-ended property funds. Admittedly, market sentiment will move the discount or premium at which property investment companies trade, sometimes substantially. But the underlying portfolio is protected from the short-termism of investors who stampede for the exit when valuations fall, and rush to buy again when prices are high.

So a mixture of investment companies generating income from equities, together with some alternative assets for diversification, could offer a way for pensioners to access a growing income without consuming their capital via an annuity purchase.

Now for the caveats. There is, of course, a crucial difference between the guaranteed income an annuity provides, and the income from a portfolio of investments, however good the track record. Moreover, the closed-ended nature of investment companies, their ability to gear and their changing discounts and premiums, are likely to lead to a greater volatility of capital return than an open-ended fund (though investment companies have outperformed open-ended equivalents over time). This makes investment companies suitable only for pensioners who can accept this risk to capital, whether due to the existence of other assets or income sources, or simply because the accumulated pension savings are large enough to supply a substantial natural yield with little need to dig into capital.

It is worth bearing one point in mind about gearing. It is often seen, not unreasonably, as a factor that adds risk. But from the point of view of an income investor, gearing could actually give investment company managers the flexibility to steer clear of high-yielding stocks that they would otherwise feel under pressure to include in portfolios. Instead, an acceptable yield can be offered by gearing a slightly lower-yielding portfolio, giving fund managers a wider choice of stocks and enabling them to steer clear of value traps. In effect, gearing risk is substituted for stock selection risk, and for those more worried about a dividend cut than increased capital volatility, that could be a good trade-off.

Nick Britton is head of training of the Association of Investment Companies