Visiting the Alliance & Leicester IFA conference recently, I was asked whether long gilt yields are ever likely to return to levels which will allow decent annuity rates to be paid and what is a reasonable level of income that can be drawn from a portfolio? Answers to both questions are closely interlinked.
I had been haranguing IFAs at the conference with a plea for lowering clients' expectations on likely investment returns in the future. It is not that I am bearish but rather that I believe we are in for a prolonged period of investment returns that are significantly less than those to which we became used during the 1980s and 1990s. This has implications for all manner of things, not least how much you need to save in order to enjoy a secure retirement income.
In the past, retirement income has been equated with annuity rates, which have been less than impressive over recent years thanks to gilt yields. Nor does there seem any likelihood that the situation will improve. Deficit financing is, by and large, a thing of the past. Even the US has a huge budget surplus, part of which is being used to retire the national debt. In the UK, £20bn worth of gilts were redeemed in December. There are no signs of replacement issues. But, unfortunately, insurance companies remain natural buyers of long-dated gilts, which explains the reverse yield curve that presently exists. Long gilts now deliver very poor value for investors, particularly those who pay higher-rate tax.
You can still obtain fairly high yields from alternative comparable investments. In the pure fixed-interest market, many corporate bonds are returning much more than the equivalent gilt-edged security. Nor is there any shortage of supply – the telecoms industry has seen to that. But the yield premium offered reflects the inherent risks. The risk of failure on redemption is less important than the fact that these issues are likely to prove very volatile, with yields – and thus prices – leaping around all over the place to reflect the current view on this particular market. But this uncertainty at least means you should find good value somewhere.
Take zero-dividend preference shares as another example. It was clear from the IFAs who attended the Cornwall AITC forum that the appetite for zeros is considerable. Where else can you achieve a tax-free return of 8 per cent on your capital? You would be lucky to obtain 5 per cent in the gilt market. True, there are risks, although several speakers pointed out that no zero-dividend preference share has yet defaulted. Of course, the tax-free element assumes you are able to utilise your annual capital gains tax allowance. If you are looking for income, though, you would be as well not to ignore this sector of the market.
Which brings me round to a reasonable level of income. In my view, total return is now the way forward. In part, this is driven by the fact that the dividend income on ordinary shares is unlikely to return to the levels we enjoyed in the past. This is not just a function of higher markets. The abolition of advance corporation tax means share dividends are far less attractive to gross funds than in the past. Given that pension funds are the biggest single owners of UK plc, then it is no wonder companies will be more concerned with finding alternative means of delivering value to shareholders.
Stripping capital gains from zeros is a way of generating total return efficiently. But, in an era of lower investment returns, I would be careful not to withdraw too much each year from a portfolio over a lengthy period of time. Perhaps 5 per cent is reasonably safe. However, assuming the withdrawal is without regard to the payment of tax, then the chances are that from a portfolio of equities you will be taking more than twice that withdrawal out of capital rather than net income.