This week, we’re going to be talking about Investing for Income, a common question from clients, particularly in recent years.
Investing for income is one of the hottest questions I get asked by prospective clients right now. Since interest rates were slashed five years ago, people who previously just put money in the bank and lived off the interest had to come up with a different strategy. Someone with £250,000 in the bank at 6% would earn £15,000 gross per year. At 1% that’s only £2,500 per year. Could you cope with a pay cut of 85%? Neither could many of these people. They were faced with either eroding their capital – something many people are loath to do – or changing the way they invest.
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Taking an income from an investment means investing in a different way to if you’re after all-out growth. So let’s look at the key things you need to know first if you’re thinking of investing this way, and then as usual, we’ll look at what you have to do.
Everything you need to KNOW
1 – Income is derived in three main ways
Income is a catch-all term. When it comes to investing, income is generated in three main ways:
- Interest – When you deposit money with a bank or building society, they get to use your money for their own ends: lending out to borrowers and investing etc. The bank pays you for the privilege, and this payment is called interest. Also, if you hold gilts or corporate bond, the income from these is interest.
- Dividends – When you own a share in a company, and the company makes a profit, part of that profit is often distributed to the shareholders. That payment is a called a dividend. It is not just shares that pay dividends, but funds, which themselves own shares.
- Rental Income – When you own a property which is rented out, the money your tenants pay you is called rent
Each of these types of income is different, particularly from the point of view of the tax man. Each has its uses, advantages and disadvantages, but the end result is the same – money is generated by the asset you hold, be it a cash deposit, a holding of shares or a bricks-and-mortar property, and that money ends up in your bank account to be spent.
2 – Natural Income and Total Return
Many people think that when investing, the only way to think about income is what advisers would call ‘natural income’. Income from a bank deposit is produced by the deposit and can either be added to the deposit holding, or paid out to your bank account. Likewise, a dividend can be used to buy more shares or units, or can be paid into your account.
The natural income is the income produced by the asset. Often, but not always, the natural income will fluctuate. And, as I said in the introduction, if you are depending on that income to live, and the income goes down, you have a problem.
Another way to think about income is as total return.
Total Return is a bigger subject than you might think, with lots of scholarly research being done into it, most of which is way over my head. But think of total return as the combination of both natural income, and the increase in value of the asset itself.
Now this does not apply to bank accounts. If you siphon off the interest from a bank deposit a the end of the year, you will have exactly the same amount at the end of the year as you did at the start. The cash in the bank can’t grow. A pound will always be worth a pound. The interest can be added to the balance, and in year two you get interest on interest – the magic of compounding. But each pound is only ever worth a pound: pounds can’t grow!
But shares can grow in value, quite apart from the fact that they also throw off dividend income. So here, you have two strings to your bow. A share with a value of £10 might throw off a dividend of 20 pence over a year. It might also increase in value from £10 to £15 over the same year. My total return then, ignoring inflation and tax, is £5.20, or the sum of my growth and my dividend.
Thinking in terms of total return has far-reaching implications for those investing for income. If I can harness both growth and natural income to fund my lifestyle it gives me a double-edged sword to work with, if you’ll pardon the dodgy metaphor.
3 – Safe Withdrawal rate
Much of the scholarly research I was talking about has to do with the Safe Withdrawal Rate. This term refers to the rate at which you can draw money from an investment portfolio, and never have the portfolio itself run out. I’ll explain…
Thinking back to our share that both there off a dividend and grew in value, you know that you could withdraw £5.20 from that portfolio in that year, and you would still have the same amount of money in the pot that you had when you started. All you have done is siphon off the profit and the dividend.
But what if you needed £5.20 to live on next year, but in year 2 the value of the £10 dropped to £8 and the dividend was only 10p. Well you have actually lost £1.90 and you have withdrawn £5.20, so your pot of money is well down.
Shares and similar investments do not perform in straight lines; they go up and they go down.
If you withdraw money when your shares are suffering, you damage your wealth more (obviously) than if you take money out of profit. This is a kind of reverse pound cost averaging. I covered pound cost averaging in Session 41 and also in video number 151.
The safe withdrawal rate then, is a guide to how much you can withdraw from a portfolio and, assuming normal levels of volatility, you should never run out of money. The latest research I have read shows that the safe withdrawal rate depends very much on the state of markets when you begin taking that income. For years I have used a 4% rule of thumb, but that is far too simplistic, it turns out.
4 – Income is a compounding agent
When income is added to income, and you also throw asset price growth into the mix, you have a great recipe for compounding – the snowballing of money so that it gets bigger, faster. This can never happen if you spend all the income produced by an investment. All you have left is the asset value which can go down and up, but which can never be added to by buying more of the asset.
It is important then to use this powerful weapon and not to get hung up on income in the mod basic form of that word. Taking natural income is fine, particularly if you can cope with a fluctuating income and if you have enough assets. But most of us will need to work what we have as hard as possible and using income as a compounding agent is a key way to do that.
#1 – Income is derived in three main ways
#2 – There is a key difference between natural income and total return
#3 – Safe withdrawal rate
#4 – Income is a compounding agent.
Keeping those three things in mind, let’s look at the practical steps you need to take when investing for income
Everything you need to DO
1 – Set realistic expectations
As with all kinds of planning, realistic expectation are a great place to start.
I heard of a survey recently, but I haven’t been able to remember where I heard it, or the exact numbers, but the survey showed that the average income people expected to get in retirement was something like £20,000 per year, and that they thought the fund size you would need to generate an income like that was about £130,000. That’s a 15.3% income – nice if you can get it!
Assuming a 4% return, you would need a £500,000 fund to get a £20,000 per year income, so there’s quite a gap there between expectations and reality.
Everyone wants their cake and to be able to eat it, but you must set realistic expectations if you are to win with investing. Bear in mind that the prevailing interest rate from the Bank of England is at an all-time low of 0.5% and has been there for five years.
It is possible to generate a yield from an income portfolio of 3-4% per year. A Balanced investor should realistically expect to make 6-7% per year total return from a properly diversified and managed portfolio. But this figure is an average and is over at least a ten year window. Along the way there will be ups and downs, sometimes quite large ones.
When engaging in financial planning with my clients, we agree between us what assumptions we are going to make about future growth and inflation. And base everything on these. That way I can manage my clients’ expectations from the start of our relationship.
2 – Set parameters for timescale and risk
Even if a required level of income is the primary reason for investing, there are other factors which must be considered.
Timescale is one. When taking a natural income, you and your adviser need to know how long that income is likely to be needed for. Most, but not all people looking to take an income from their portfolio are in retirement. So when having this discussion with clients, I will be talking to them about the longevity in their family. I would default any financial plan to run until age 99, but I’ve had clients who had both parents live beyond that, so we do need to bear this in mind.
Risk is another factor. If a client needs a certain level of return from their portfolio, but the risk required to generate that return would have them lying awake at night, then some balance is going to need to be struck.
Timescale is an easy conversation to have with yourself, but risk is an abstract concept, particularly for those who are new to investing. I did a whole session on risk back in Session 16, so check that out for more meat on that subject.
You need to set these parameters at the start. They can be tweaked over time based on experience, but getting them right to start with will help you invest wisely.
3 – Decide: Natural Income or Total Return
One is not better than the other; it depends on your circumstances.
If you have a significant portfolio of investments, and if your income from pensions provide a nice baseline for you, the you can likely afford to have a fluctuating income from your investment portfolio delivered to your bank account once a quarter.
But if you have a small pension but have built up a portfolio of ISAs say, then that portfolio is going to be providing a chunk of your income and you may not want to have the income fluctuate.
Level of income, its frequency of payment and whether or not the income which arrives in your bank account will fluctuate. Those are the differentiators between natural income and total return. Choose which works best for you and invest accordingly.
There are people who can’t stand the thought of ever dipping into their capital. In other cases there are trusts where income is paid to one person, and the capital will one day be paid out to another. In these cases, natural income is the only choice.
For others, taking a total return approach will likely (but not definitely) provide a higher level of income in the form of regular withdrawals from the portfolio, but the investments will usually be relatively higher risk.
4 – Take a multi-asset approach
As ever with investing, the mantra of diversification – spreading your money around – is valid here. Just because you are investing for income primarily, doesn’t mean you should restrict yourself to income producing assets. Income doesn’t mean corporate bonds, for example.
As I said right at the top of the show, income is derived in different forms and each of these forms should be harnessed. A total return portfolio will have fixed interest assets in it like gilts and corporate bonds. It might also have some property in it, and some large company shares to produce a healthy divined. But it should also have some smaller company shares, maybe some investment trusts trading at a discount and other assets which should produce growth over time too.
As disingenuous as it sounds, investing for income isn’t all about income. You also need to have a mind to the future and build in some growth too.
I will always preach multi-asset investing here. My friends Rob and Rob over at The Property Podcast are doing great work dispelling some of the myths around property investing. Much as I like property, it is one asset class among many and I would never limit my portfolio to one asset class.
Have multiple strings to the bow, multiple baskets in which to place your retirement eggs, multiple assets working for you towards your income goals
5 – Plan early
It’s OK to plan for your desired retirement income five years before you plan to retire. But how much better to be giving that some thought 20 years before?!
Financial planning is at best educated guessing – I tell my clients this in setting their expectations! But while life gets in the way and unexpected events happen, when engaging with your financial planning, you should be having a mind to your end goal. For most of us, that is financial freedom or retirement, defined by me at least as not having to work in order to fund our desired lifestyle.
The entire financial planning process should be heading towards that goals and it is possible, with a knowledge of risk, returns, timescales, etc to come up with a numerical figure to work towards. That figure will represent the amount of money you need to fund your lifestyle. It will obviously be different for everyone.
A great book on this is called The Number by Lee Eisenberg – highly recommended [Amazon afilliate link]. It is an American book, but the principles are universal.
I did a video entitled What is Financial Planning quite a while ago now – it is episode 79 and is one of my most watched videos ever. This explains the process of getting to you number, the different variables involved and considerations you need to bear in mind.
Investing for income is essentially about having a desired level of income being generated by a portfolio, and making sure that income can be sustained for the rest of your life. There are many variables, as we’ve discussed, and there will inevitably be some compromise on your part as things won’t always run smoothly.
But with careful planning and managed expectations, it is possible to invest in such a way that provides a sustainable, predictable level of income or withdrawals into your bank account in order for you to get on with living your life, which is the whole point of financial planning in the first place.
As ever, I will counsel you to seek advice from a Certified Financial Planner – listen back to Session 8 for more info on how to find one.
Best of luck!
This week’s reviews
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I mentioned multi-asset investing in the main body of the session. It’s a very current term; I’m seeing it bandied around in all sorts of spheres and being used to brand new fund launches.
An asset class is simply something you can invest in. So that could be Cash, gold, shares, gilts, property, commodities and lots of other similar things. There’s loads more back in Session 10 about asset classes, so be sure to listen to that.
A multi-asset fund or portfolio, then, is one which encompasses many different types of asset. Usually the different assets will be weighted according to risk, so a more aggressive portfolio aiming for higher growth will hold more shares, whereas a more defensive portfolio looking for income and capital preservation will hold more gilts and bonds than shares.
You can build a portfolio of funds which each hold just one asset class, Or you can hold a multi-asset fund which holds multiple asset classes. Either is fine, but when you are starting out, you might want to make life easier for yourself by choosing a fund which does a lot of the lifting for you. I can’t recommend specific funds here, much as I wish I could, so you’ll have do some digging yourselves…
No weight loss AGAIN this week – for shame. This week I’m in London at a couple of awards do’s. One is the Unbiased Media Awards at which I’m up for Social Media IFA of the year and the Bluebook Newcomer. The bluebook is Unbiased’s directory of advisers who are comfortable taking to the media.
Then on Thursday I’m at the Professional Adviser Awards. Again, I’m up for two awards, one for the best client engagement for this very podcast, and the second is adviser personality of the year, which may just be an oxymoron!
I’m hoping to come away with at least one award. Four would be nice but is probably unlikely despite my sparkling personality!
Next Session Announcement
Next time we'll be talking about Getting Money in Perspective. Money is not important in the grand scheme of things, but it is very useful! I’ll be giving you some perspective on money, which might just help when it can seem like it’s all that matters in the world. If you have a question on this subject, or any other financial query that you want answering here on the show, then the best way to do that is to leave me a voicemail at meaningfulmoney.tv/feedback
That's it for this session of the MM podcast, I hope it was helpful. Did I miss anything? Do you have any questions? If so, please leave them in the comments section below.
I hope you enjoyed this session. Thanks for listening – I'll talk to you next time.