It has been said advisers place too little emphasis on income from client’s investments
“A gentlemen could jog along comfortably on £40,000 a year!” was the judgement of a man who knew what he was talking about when someone’s worth was measured by income rather than capital value.
This emphasis on income was common throughout the 19th century, as attested by numerous references in the works of Jane Austin at the start and Oscar Wilde at the end of the period.
When “jog along” Jack Lambton, first Earl of Durham, made this pronouncement, the figure was the equivalent in today’s inflated money of about £4.4m a year. His income came from coal, but the income favoured by more recent commentators is generally rather more diversified. And there are indeed modern-day financial practitioners who believe we place too little emphasis on income from client’s investments.
The equity income story is an old one, but it has considerable merit. Now there is a modern twist on it for retirement income from Aegon investment director Nick Dixon.
Total return investing has become more fashionable in recent years, but income-based investing still has its adherents, with Dixon one of the most convincing as we witnessed at the recent Platforum conference.
What follows is my take on his views. In the 1970s and 1980s, the equity income story was mostly confined to UK equities. Then, as now, UK equities saw significantly higher yields than those of most other markets and dividends from equity income funds had held up well, even through the horrors of the early-1970s bear market.
Looking at three of the main asset classes in terms of their income, we have in some senses returned to the 19th century – at least in terms of the relative yields. Back then, well before the cult of the equity, shares generally yielded more than bonds in recognition of their greater capital risk. Today, UK gilts yield a mere 1.3 per cent, global equities 2.3 per cent and UK equities a thumping 4.1 per cent.
The equity income story is an old one, but it has considerable merit. Now there is a modern twist on it for retirement income
So, what is the case now for equity income investing?
Well, first of all, it has a good track record for growing in the long term. It has produced compounded annual growth of an impressive 6.6 per cent since the turn of the century. All this despite going through the greatest recession since the Second World War.
Better yet, although capital values bounce around a fair bit, the annual income from equities is pretty steady, with annual volatility only 9.3 per cent and a maximum one-year fall of just 4 per cent, compared with capital volatility of 14.7 per cent and a maximum one-year fall of 21.5 per cent.
The level of income clients decide to take from their investment portfolios is then dependent on whether they draw more than the yield. Obviously, the more investors draw in total the more they eat into their portfolio’s capital value.
Aegon has produced a back test of the proposition starting in 1998, showing different levels of withdrawal from a £400,000 portfolio, ranging from 3 per cent annual withdrawal plus a 1 per cent annual fee, up to 5 per cent plus 1 per cent. At 4 plus 1 per cent, the portfolio kept its original nominal capital value, while at the 5 plus 1 per cent top end the nominal capital value roughly halved.
Damping down the capital fluctuations to reduce the impact of the sequencing risk so evident in this latest 20-year period would be possible by investing part of the portfolio in cash or bonds. But it would be at the expense of cutting the yield. Boosting the yield would be possible by increasing the exposure to UK equities, but at greater risk to income and capital.
One of the strengths of the investing for income approach is it is relatively easy for advisers to explain and clients to grasp the two risks: to their spendable income and to their residual capital. Most of us do mental accounting, separating income from capital. It is like the fruit and the tree, or the rent and the property sale value. Then deciding to draw a bit more of the capital value year by year covers most of the decisions clients need to make about risk.
Many advisers will dismiss the approach, but it is certainly worth thinking about.
Danby Bloch is chairman of Helm Godfrey and consultant at Platforum