New pensions freedoms – new options
The pension freedoms introduced in April of this year are likely to see many investors remain invested long into their retirement, rather than buying an annuity. The type of investment best suited to this new approach to retirement income has been hotly debated, but it is clear that income, of itself, will not be enough: That income must exhibit growth, it must be consistent, and it must be diverse.
4 September 2015
For a retiree with potentially 20-30 years of retirement ahead of them, dividend growth is likely to be more important than the absolute level of dividend. An income investor buys a portfolio of shares for £100 and it pays an income of £3. All the investor needs is for that income to firstly, be maintained, and then, to grow in line with inflation. In other words, that investor needs to get £3 in the first year, then, say, £3.10. the next, and then £3.20 in the following year.
The income investor shouldn’t therefore be too concerned if the share price rises to £120 or falls to £80 (though that may influence new buyers into the fund). However, investors have the added advantage that equities have tended to perform better over the longer term. The arguments for ensuring growth in capital are similar to those for ensuring growth in income – an investors’ pot keeps pace with inflation, which can be vital for those facing, for example, care home fees, but also for those who want to leave a legacy. A fund’s potential to increase dividends year on year is also an attractive proposition for income investors- something the Schroder Income Growth Fund plc has done year on year since its inception in 1995.
There is another nuance in the current environment. With UK and US policymakers on the cusp of raising interest rates, those companies that simply offer a fixed level of income are likely to become less highly prized. Those companies that also offer growth in their dividends are unlikely to come under the same pressure.
It is also worth noting, that a high absolute level of dividends is often a sign of distress: Companies with very high dividend yields tend to be those where the market is concerned that the dividend is at risk. The income investor may buy at a yield of 7-8%, but his annual income will fall if the company then lowers, or abandons its dividend. This is unlikely to be the right option for someone seeking consistency and reliability of income over time.
While no investment can match the guaranteed returns of an annuity, investors will want some reassurance that a trust has exhibited consistency of income payments in the past and has the capacity to continue doing so in future. It is clear that investment trusts have something to offer in this regard. Unlike open-ended investment companies, investment trusts can reserve a portion of each year’s income in buoyant times to pay it out in leaner times, leading to greater consistency of pay-outs for investors.
Many investment trusts have built up significant reserves on which they can draw. Statistics from the Association of Investment Companies show some trusts’ reserves as high as 10 years, and many will have enough to pay up to a year’s worth of income. They can also pay income out of capital if they choose, giving them greater investment flexibility. The Schroder Income Growth Fund plc has around 4% of its net asset value held as reserves, equivalent to around six months’ worth of payouts.
Other techniques, such as the judicious use of gearing and limited writing of covered call options can also be employed by investment trust managers to boost yield over time or top up the revenue reserve account. The gearing on the Schroders Income Growth Fund plc currently sits at 9.2%.
Equally, for many investment trusts, the board makes the commitment to pay a dividend. The Board ensures that the investment manager remains wedded to this goal and will challenge them if it isn’t met. This differentiates investment trusts from the open-ended sector.
The investment trust structure also allows investment trust managers greater flexibility in the investments they choose. Investment trusts have a fixed pool of assets and managers do not have to navigate inflows and outflows. This is important for dividend investors. Dividends in the UK equity market can be relatively concentrated if investors are confined to the most liquid parts of the market.
There is considerable dividend diversity in the market. The recent Capita report on dividends in the UK market found that rather than the income stalwarts such as healthcare or utilities, it was areas such as construction, general retailers, household goods, media, telecoms (fixed line), property, and technology sectors that posted the strongest growth in dividends at the start of this year.
This diversity is important. Targeting absolute dividend yield at the expense of either diversity or growth in income is likely to be, at best, a short-term strategy and at worst, will see investors targeting those parts of the markets where dividends may be at risk. This is particularly true in the current market environment where certain parts of the market, such as commodities, look particularly vulnerable.
In building a diverse dividend portfolio, it can be worth judiciously incorporating non-UK stocks. The Schroder Income Growth Fund plc can invest up to 20% of its assets in non-UK stocks. While it may not always use the full extent of this flexibility, it can help to tap into sectors that may be poorly represented in the UK market or where the best companies lie outside the UK. This diversity can also help ensure consistency, giving the fund managers a broader choice in more difficult market conditions.
The new pension freedoms open up a range of options for investors to build and grow their retirement income over time. An investment trust cannot replace an annuity, but it has certain characteristics that ensure pay-outs are likely to be more consistent, diverse and exhibit stronger growth than many other options for retirees. As such, we believe they merit consideration within a retirement portfolio.
The Schroders Income Growth Fund plc is managed by Sue Noffke who has been part of Schroders’ experienced UK Equity Team for over 20 years. The Company’s principal investment objectives are to provide real growth of income, being growth of income in excess of the rate of inflation, and capital growth as a consequence of the rising income. The Company targets the attractive income and income growth potential provided by UK companies and has a record of increasing dividends each year for the past decade.
This combination of income and growth is vital for investors looking to sustain their wealth over a 20-30 year retirement.
Other UK Investment Trusts include Schroders UK Growth Fund Plc and Schroder UK Mid Cap Fund Plc.
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