In search of income protection

Cherry

With interest rates having been stuck at historic lows for more than a decade, millions of Britons now rely on the stock market for income. That includes many retired savers who need the dividends paid out by stock market-listed companies to generate their pension income.

However, there is a problem. Many companies were forced to slash their dividends last year as their earnings plummeted amid the Covid-19 pandemic. And while the prospects of many of these companies now look to be improving, a return to previous levels of dividend payments may take some time.

New figures from the shareholder registrar company Link show just how serious this problem is. Dividends fell 43% last year, Link says, and the decline continued into the first quarter of 2021, when pay-outs from companies were 27% down on the same three months of 2020.

Link does expect some improvement during the rest of the year: it is predicting total UK dividends will rise between 11% and 17% over 2021 as a whole. But that will still leave pay-outs between 33% and 37% below pre-pandemic levels and Link does not expect them to regain previous highs until around 2025.

Income investors feel the pain

If you are dependent on those dividends for your income, this is a pretty difficult situation. Many investors invest in the stock market using funds in order to get some diversification, but this has not always helped. The average UK Equity Income open-ended fund reduced its pay-out to investors by 29% last year as the companies in its portfolio cut their dividends. There may be some better news to come this year, assuming Link’s projections are right, but these funds will only be able to mirror the modest bounce-back currently expected.

However, there is one type of investment that has been able to insulate income seekers from these issues. Investment companies managed to maintain their pay-outs last year – and in many cases to increase them. Of 23 UK Equity Income investment companies, only two reduced their dividends, while 19 paid out more. And of these 19 funds, at least six have already indicated that this year’s dividend will be higher again.

How did they defy the odds? Well, while most investment funds are required to pass on all the dividend income they receive to their investors, different rules apply to investment companies. They are allowed to retain some of the dividends paid by the businesses in which they invest in order to build up reserves. These reserves provide a safety net that enables investment companies to keep paying dividends to their own shareholders when times become more difficult.

Safety in numbers

The question is whether investment companies can continue providing this sort of protection. They were able to maintain or increase income distributions last year by drawing down on their reserve funds. But these funds are not infinite – if dividend payments do not recover, investment companies will eventually exhaust the pots of cash put by to protect investors.

The good news is that we are some way off this point. The average investment company has enough reserves left to maintain income payments to shareholders for around eight months according to the latest data from Numis Securities, even if not another penny of dividend flows into their coffers. In practice, even in last year’s dire marketplace, investment companies still picked up more than half the dividends they had received last year. So, with a recovery – albeit a modest one – now forecast, there is plenty of breathing space.

There are no guarantees. Some investment companies have found themselves forced to reduce pay-outs already. And the market outlook remains deeply uncertain; if the pandemic returns and the economy crashes once more, dividends will likely dive again.

Still, the smoothing effect that investment companies provide has really proved its value over the past 12 months. For anyone who cannot afford to see wild fluctuations in their income, these funds have been a rare bright spot in a very dark time.