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.

| 13 min read

With the cost of living continuing to rise, interest rates close to zero and little prospect of a significant improvement in the near term, many people have been considering investing to provide much-needed income, including through pension drawdown.

This means foregoing the security of cash and taking on more risk. Committing a considerable sum of money to the markets, even if you are an experienced investor, can be somewhat daunting. Provided 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

Whatever amount of money you likely need to access in the short term (up to five years) is generally best held as cash. Clearly, with interest rates at close to rock bottom and 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.

Even a well-diversified portfolio could suffer this sort of drop in the short term. Although it wouldn’t be our central scenario, a misstep by central banks in terms of putting up interest rates too aggressively and too quickly, or a more sustained period of inflation that requires higher interest rates, could mean a simultaneous shock for both equities and bonds. Those with ample cash for their short term needs don’t need to worry about this eventuality and may even benefit from a slight improvement in interest rates on money in savings accounts if they are not locked into a fixed term product.

Committing a considerable sum of money to the markets, even if you are an experienced investor, can be somewhat daunting. Provided 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 a strategy

When investing for income you are going to need to decide on your strategy, method of taking income and how much. Taking income means you don’t benefit as much from the ‘compounding’ of returns compared with investing for growth, which means getting your strategy right from outset is very important – 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’s 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.

The natural income approach can restrict you in terms of maximising returns because non-yielding or low-yielding areas would be excluded if you are maximising income – and they might perform better than low or non-yielding assets. However, the natural income approach means you are never selling capital (provided that the income alone meets your needs), and it ensures this remains intact to generate future income.

Income producing areas can also be less volatile – though of course there are no guarantees – which can help, plus 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.

Investment ideas

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.

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 as presently yields around 4% (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.

Generating an income from your investments

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