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Generating an income from your investments

As inflation bites, many people have been considering investing to provide much-needed extra income, but care is needed even if you are an experienced investor.

| 15 min read

With the cost of living continuing to rise, even increased interest rates have not been enough to outpace inflation. Many people have been considering investing to provide much-needed income, including through pension drawdown.

This means giving up the security of cash and taking on more risk. Committing a large sum of money, even if you are an experienced investor, can be somewhat daunting. But if you are happy committing for the long term – say ten years – and set out to generate returns from a variety of sources then you should be well equipped. However, all investments can fall in value as well as rise, so it is important to hold a wide range to avoid over-reliance on one or a small number of areas.

Cash remains important for short-term needs

Any money you are likely to need access to in the next five years is generally best held as cash. Clearly, with inflation presently at elevated levels there is a temptation to try and make the money work harder, even in the short term. However, the rules of sound financial planning still apply, and cash could be the lesser of two evils. Better to be behind inflation than risk a 10% or 20% fall in capital, or more, by risking investing the money in markets over a short time period.

But your emergency savings fund should still work as hard as possible. Even with recent increases in interest rates, your high street bank might not be offering the best rates on your deposit accounts. Online platforms can often find better interest rates from smaller or “digital” banks that are competing for savers’ cash. Depending on your near-term plans a mix of easy-access, fixed-term, and notice accounts can provide both flexibility and better returns.

See if you can find competitive savings rates with Charles Stanley Direct Cash Savings.

Committing a large sum of money to the markets, even if you are an experienced investor, can be daunting. But if you are happy committing for the long term – say ten years – and set out to generate returns from a variety of sources then you should be well equipped.

How to measure income from investments

When you are weighing up an investment for income you can get an idea of how much it produces by looking up its ‘yield’ – generally this is the amount of income it has paid over the past year divided by its price, and it is expressed as a percentage.

  • For instance, a share valued at £1 that has paid 5p per share in dividends from its profits over the past year has a yield of 5%.
  • This could be different going forward because the dividend could be higher or lower, plus of course the share price might change, but it can give a useful indication of the possible amount on offer.

It’s also important to note that some yields you may come across are forward looking or ‘prospective’ rather than historic. This is especially the case with bonds - which are effectively loans to companies and other institutions. In the case of corporate bonds, the borrower is a company, and for gilts the borrower is the UK government. You should always treat yields as variable and not guaranteed.

For funds, collective investments that invest in a range of shares, bonds or other asset classes, yields work in a similar way. If you are looking to draw an income from funds, then look for 'income' units. These pay out any income the fund generates, whereas 'accumulation' units roll the income up, effectively turning the income into growth.

Deciding on an income investing strategy

When investing for income you need to decide on your strategy, how you take the income and how much. Taking income means you don’t benefit as much from the ‘compounding’ of returns compared with investing for growth, so it’s really important to get your strategy right from the start. Especially if you are relying on this income rather than it being a ‘top up’ to guaranteed income from an occupational pension, state pension, or an annuity.

There are two main approaches:

  • invest for ‘total return’ and withdraw what you need each year; or
  • invest in income producing assets (dividend-producing equities, bonds, property etc.) and take the ‘natural income’ these investments produce.

As long as the natural income meets your needs you never need to sell investments to free up capital, which ensures this remains intact to generate future income. However, it can restrict you in terms of maximising returns. This is because non-yielding or low-yielding areas would be even though they might perform better overall.

Income producing areas can also be less volatile – though of course there are no guarantees – which can help. Keeping to natural income can mitigate the effects of ‘pound cost ravaging’. This is the term used to describe how the impact of capital withdrawals amplify the effect of the volatility of returns on a portfolio.

Smoothing returns can be important compared with the ‘accumulation phase’ of investing when volatility doesn’t matter so much and can even work to your advantage. It is much more challenging to manage a portfolio where income is being taken.

A very diverse approach that combines a bit of natural income with maximising total return tends to work well, but obviously it depends on income needs too. The less income required the easier it is.

By blending a variety of investments that are ‘uncorrelated’ (i.e. their price movements are largely independent of one another rather than moving up and down in tandem) it is possible to build a portfolio more resilient to market fluctuations but that can still deliver a consistent level of income.

With this in mind, what are the main building blocks to consider when constructing a diverse portfolio for income?

Smoothing returns can be important compared with the ‘accumulation phase’ of investing when volatility doesn’t matter so much and can even work to your advantage.

A growing income from equities

Of the major asset classes available to income investors, shares or equities are appealing because they offer the potential for a growing income as profits increase. Although investing in the stock market generally means accepting a greater degree of ups and downs, it offers the greatest opportunity for growth in both income and capital. Shares represent a stake in a business, and as a shareholder you participate in the growth of a business if it does well and often receive a share of the profits through dividend payments.

Global equity income funds are one option worth considering. They invest in dividend producing shares from around the world ensuring broad geographical and sectoral coverage. There is also a case to made for a bit of specific UK exposure. With the FTSE 100 yielding well over 3% a year presently (variable, not guaranteed) there is an attractive starting income on offer, as well as the potential for the income to rise over time to help combat the effects of inflation.

A steady income from bonds

To balance the volatility of equities and help smooth overall returns, investors often add less volatile investments to their portfolio, notably bonds. Escalating inflation fears could upset the bond market, but in the event of lower than expected inflation and interest rates, including a ‘growth shock’, bonds could come into their own.

Typically, bonds pay a fixed amount of income each year (known as a coupon) and repay the original capital at the end of the term. Income varies according to the issuer of the debt. More risky companies have to pay a higher yield to entice investors, while low risk entities (such as many governments) can issue debt with low yields, perhaps in line with general inflation or interest rate expectations, reflecting the minimal risk of default (non-payment of income or capital).

Between issue and repayment investors can buy and sell bonds just like any other investment, so values fall as well as rise and you could get back less than you invest. Prices will change according to several factors including changing interest rates, inflation expectations and the creditworthiness (or “rating”) of the underlying company or entity. In the event of bankruptcy, bond holders are a creditor and could receive a proportion of remaining assets, if there are any, once the company is liquidated. This is an important distinction between equities and bonds as in the event of liquidation an equity holder would be likely be last in the queue to receive any money and could receive nothing at all.

Bonds are considered lower risk than equities but have lower potential upside and don’t usually provide an income that grows. However, their lower volatility and ability to provide a consistent income makes them an attractive as a source of income in a portfolio, and more cautious investors may decide to have a higher weighting to bonds than equities. Over long periods bonds and equities do not tend to move in tandem, though over shorter periods they can.

Higher yield options

Investors are naturally attracted to investments that produce a high level of income. However, a high yield can also be a warning sign. There is likely to be a good reason why an investment yields so much. If it is a share there could well be expectations of a dividend cut. For bonds, higher yield means higher risk, and more chance of default and capital loss. However, there are funds designed to produce high levels of income while aiming to control these risks through diversification, and sometimes through more sophisticated techniques including the use of derivatives.

These can sometimes be useful to bring something different to a portfolio. For instance, as well as providing a higher yield than safer, investment grade bonds, high yield bonds react differently to changing economic circumstances. They are more likely to be resilient in a strong economic environment where company bankruptcies are falling, whereas the threat of higher inflation and interest rates in these circumstances may have a greater effect on gilts and other bonds with lower yields.

Alternative asset classes

A ‘traditional’ portfolio comprises mainly, or perhaps only, equities and bonds. Yet there are other asset classes that can help diversify a portfolio, and arguably these are especially important at present with a greater tendency for bonds and equities to rise and fall in tandem.

Many ‘alternative’ investments such as targeted absolute return funds don’t provide an income. They can still be part of an income portfolio, but their inclusion would reduce the overall level of income produced, and it would be necessary to weigh up their benefits in terms of diversification against this. Fortunately, there are several other areas that do provide an income as well as diversification potential.

Property investment trusts can provide an attractive income and some capital growth over the long term – potentially outpacing inflation. Meanwhile, infrastructure projects can potentially provide investors with an attractive, income-orientated return. Typically, funds own a variety of assets, such as hospitals, schools and toll roads, which are often backed by long-term revenue streams from local or central government and tend to be uncorrelated to the wider economy.

Can I get a monthly income from my investments?

It is certainly possible to boost your income from your investments. There are even managed funds that do all the hard work for you, and which aim to produce a regular flow of money.

Think about investing in a range of shares, bonds and other investments where the pay-out periods are spread across the year. However, your focus should always be on identifying quality investments first and foremost. This might mean accepting that your income will not be consistent from month to month. You could also use capital gains to supplement the level of income from dividend returns.

But there is a downside to wanting a regular income – even if using a managed fund. If dividends and capital growth are lower than the desired distribution, some of the capital will be used to make up the difference. If this is sustained for a long period of time, it could eat into your ability to generate income in the future.

Where can you invest for regular income?

The Charles Stanley Direct platform provides access to more than 12,500 investments including stocks and shares, bonds and funds offering growth and income opportunities depending on your objectives and risk profile. The UK stock market is often regarded as comprising many “value” investments; these are often companies where the majority of the total return is derived from dividend income rather than reinvesting profits for future growth.

A mixture of UK government and corporate bonds, and good quality UK equities could deliver a level of income supplemented by infrastructure and other income generating funds could deliver a level of income.

If you are looking for investment funds to fill a gap in your portfolio our Preferred List could help. The collection is chosen by our Research Team to represent our best ideas across the major sectors for new investments.

Alternatively, for those simply wanting a well-diversified income portfolio in a single investment, Charles Stanley Monthly High Income is monitored and rebalanced by Charles Stanley experts and presently yields around 5% (variable, not guaranteed).

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

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