Creating a sustainable monthly income

There’s nothing new about funds that pay investors a regular income of some kind. In fact, taken as a group, such funds are one of the cornerstones of the investment management industry.

This simple fact can make it difficult to understand why such a well-established part of the investment firmament has been so slow to fill the huge gap left by the effective demise of the lifetime annuity. Back before the Global Financial Crisis (GFC), when the West still had interest rates to speak of, annuities paid out a meagre but guaranteed monthly income which for decades provided a ‘sleep at night’ solution for millions of UK retirees.

Changing times

Unfortunately, annuities were one of the first major casualties of the new era of super-low interest rates meaning that the income from a lifetime annuity is today around the lowest it’s been in some 300 years. As a result, more than half of the UK’s annuity providers have simply ‘upped stumps’ and closed to new business in recent years.

In the meantime, very few fund managers have launched products that fill the void by paying monthly income while still fewer offer income ‘smoothing’ which makes each month’s income payment broadly similar in size. 

This is crucial for clients that need an income they can rely upon for their day-to-day needs as even the highest yielding portfolio will quickly lose its utility if the pay-outs veer between famine and feast every month.

This is a great shame as within the next 20 years or so, around a quarter of the people living in the UK – about 17m people – will be aged 65 or over in the country that provides the lowest state pension in the developed world.

Old problem, new solution

Probably the main reason that so few robust monthly income solutions have been launched is that there’s no single asset class that can be relied upon to deliver a sufficiently high level of income, in consistent enough dollops, to do the job.

To really deliver on this sort of mandate requires the broadest diversification across asset classes such as equities, bonds, property and alternatives as well as different investment strategies and product structures. 

Any portfolio aiming to generate a strong and sustainable level of income in every month of the year will need to pull all these levers in order to ensure there are enough opportunities germinating every month to keep your clients’ income payments in a consistent band. 

Ultimately, this requirement makes monthly income funds a multi-asset investment discipline and also helps explain why relatively few specialist asset managers have launched an offering here. 

Concentrating too hard…

To illustrate the risks of relying on just a single asset class or geographic market, we need look no further than the storied FTSE 100 Index – a ‘grandaddy’ of income strategies thanks to its long history of generous dividend payments.

Today around two-thirds of the dividends paid out by ‘UK plc’ derive from just 20 companies. The oil and gas sector dominates the picture accounting for around 18% of the total with Royal Dutch Shell alone accounting for 14% of all ‘UK divvys’. The basic resources (mining) and the personal and household goods sectors also both account for more than 10% of UK dividends, with the miners accounting for £1 in every £9 paid out in dividends in 2018 thanks to a bumper year. 

Meanwhile, dividend cover – a measure of how well each company can afford to meet its dividend payments – looks worryingly thin in places, especially among the country’s 10 biggest dividend stocks. Other problems include the fact that many of the UK’s biggest dividend payers – such as Shell, BP and HSBC – pay dividends in dollars. This introduces currency risk to as much as 40% of the total dividends from the FTSE 100.

And, because UK companies generally pay their dividends in two instalments each year (not including any special dividends) and they’re free to choose when (or if) they make these payments, the income stream from the UK stock market is as bumpy as a country road! This explains why most UK equity income funds still pay income quarterly and why their distributions are so lumpy.

All this means that while UK equity income strategies are a core holding for any monthly income portfolio, they can’t be relied upon in isolation. The same is broadly true of every asset class or investment structure; each has its own strengths and weaknesses and will pay out income in a variety of ways at a wide variety of times. 

The trick to building an income portfolio that’s resilient enough to deliver a consistent and sustainable level of income every month of the year is to capture a diverse range of future income streams and then to sit down and do your sums. 

Counting the pennies

At some level, most income portfolios are a synthesis of the manager’s top-down view of the world and the cost implications that come with different types of asset, product structure or investment strategy. It’s the same for a sustainable monthly income portfolio, but with an added dimension.

This is the need to ensure that while the portfolio is well diversified across different asset classes, it’s also protected from lumpy income streams. There are two parts to this.

The first is to construct a portfolio sufficiently diverse so that every month of the year it receives income payments from a clutch of different holdings – whether they’re equity or fixed-income funds or alternative strategies. 

The second step is to plan this income stream over a full 12 months, bearing in mind that the OEIC structure doesn’t allow earned income to be passed forward to the next financial year (unlike closed-ended funds that can pass income forward indefinitely). Such arithmetic allows us to set an achievable, sustainable bar for the income generation in the portfolio. 

By harvesting the peaks in income that come along and holding them back to help buoy the occasional troughs, we can create a smoothed income stream that pays clients a competitive but, most importantly, a sustainable level of income every month of the year.

For further information on the Quilter Investors Monthly Income range, please click here 

For Investment Professionals only. Past performance is not a guide to future performance and may not be repeated. Capital at risk. 

This communication is issued by Quilter Investors Limited ("Quilter Investors"), Millennium Bridge House, 2 Lambeth Hill, London, England, EC4V 4AJ. Quilter Investors is registered in England and Wales (number: 04227837) and is authorised and regulated by the Financial Conduct Authority (FRN: 208543).

For further information and to access the KIID and prospectus for the Quilter Investors Monthly Income and Quilter Investors Monthly Income and Growth Portfolios, please visit the Quilter Investors website.

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