Neil Mumford blog: Searching for reliable income in an unreliable world

Eight years and counting. That’s how long the UK has been shuffling along with rock-bottom interest rates. And though this may seem good news for borrowers, it has been a gloomy time for anyone with savings. With slowing economic growth in the wake of the Brexit vote, it’s highly unlikely that we’ll see a significant rate rise any time soon. So if you want your money to grow, where on earth do you put it?

The risk of doing nothing

Investing in stocks and shares (equities) is often thought of as ‘risky’. However, today there is a less obvious but potentially greater risk to your money: the steady erosion of it through low interest rates and inflation. Pensioners are already feeling its effects – with interest rates so pitiful, many people in pension drawdown schemes have had to deplete their capital to meet their income needs, rather than living off the growth. This in turn will cause their pension pot to shrink faster.

So how do we achieve a better income from our savings – even one that increases year on year? There is of course no sure-fire solution to suit everyone, but if you are frustrated by the returns on cash savings then it may be time to talk to your adviser about investment trusts.

Introducing investment trusts

An investment trust is a type of collective vehicle, which is a listed company with its shares quoted on the UK Stock Exchange or other recognised exchange, which means that they have a limited number of shares in issue. They invest in the shares of other companies, fixed-interest securities, unquoted securities, property and other types of investments.  As an individual investor, you can potentially benefit from the investment trust’s performance by buying shares in the company. The shareholders’ interests will be looked after by the trust’s independent board of directors. The board will also appoint an investment manager to manage the underlying investments – this manager can be replaced at any time, should the directors of the company feel that is in the interests of the shareholders.

Why consider them?

The one thing that we must accept – if we want a higher income than those available on deposit – is that we have to take some of our savings out of the bank or building society and increase our investment risk. You may not like the idea of ‘increasing risk’ – but consider that by doing so, you are actually decreasing another risk (that of inflation).

Investment trusts aren’t nearly as popular as unit trusts (which outsell them by around 10 to 1) and historically few financial advisers have recommended them. So why should you consider them now as a source of retirement income?

Investments trusts have two main advantages in particular that can enable them to deliver higher returns. Firstly, they may trade at a premium or at a discount. In simple terms, if the company’s share price is higher than the underlying stock market value of the trust, it is trading at a premium. If it is lower, it is trading at a discount. If you can buy into a trust when the discount is wide and sell when it narrows, you will boost your returns (though the reverse is also true, which is what makes this a risky strategy).

Secondly, investment trusts may make use of gearing. This means they can borrow money to buy more shares (unit trusts cannot do this) and potentially make a greater return than the cost of the borrowing. Again, this also brings greater risks – because if the market falls, any losses will be magnified.

Income

Due to these ‘risks’ you should consider an investment trust as a long term purchase. Although we have focused on the risks, we need to consider the other arguments in favour of these vehicles. The big plus of an investment trust is that it is run for the benefit of its shareholders, not the investment house. In the main, just like individual companies, many investment trusts pay dividends to shareholders. They also have the ability to income back in their reserve account, which helps to maintain or increase these dividend pay-outs each year.  Interestingly there are ten investment trusts that have increased each year their dividends for over 40 years and a further nine that have increased their dividends each year for more than 20 years (known as dividend heroes).  This at a time when individuals have seen the interest earned on their savings steadily reduce.

A dividend hero in action

To demonstrate the benefits of taking a long term approach of investing into an Investment Trust, I will use Bankers Investment Trust, as an example, a company which has increased its dividend, each year, for the last 49 years.

If you had purchased this trust at the end of October 2007, its share price was £5.00 and the annual dividend payable per share was 10.24p. Assuming you had invested £10,000, you would have purchased 2,000 shares and received in the first year a dividend of £204.80, more or less the equivalent of 2%. Lower than that available on deposit at that time.

During the financial crisis the share price was hit hard and fell within two years to as low as £3.41 – yet the annual dividend had increased to 11.06p per share. Some investors may have panicked to see their share price fall by over 40 per cent – however, if they focused on why they had bought the trust in the first place (i.e. to generate income) then were rewarded for holding their nerve.

If we fast forward to 1 July 2016, the share price stood at £6.57, which would meant that their capital was now worth £13,140.

This year they would also have received, a dividend of 15.80p per share, which is 3.16% of the original investment. This means that since 2007, the annual dividend received, had increased by 54 per cent, which is well above the rate of inflation over the same period and also at the same time that interest rates on deposits have fallen.  Over nine years, both a rising income and an increase in the investment.

This has been during a time of economic turmoil as we recover from the financial crisis and as mentioned earlier when many retirees have seen deposit rates hit rock bottom and the erosion of their savings to provide income for themselves and a future that currently looks bleak for interest rates.

I have used Bankers as an example, but this can be replicated from a number of these dividend heroes, that have made a massive difference to some of their investors’ lifestyles.

In my opinion this demonstrates the benefits that can be achieved from accepting volatility and risk and taking a long term investment decision. Investors also have the ability to diversify their risk and income stream by investing into a combination of investment trusts, along with their unit trust cousins to help achieve their income objectives.

Please note that the investment trust mentioned in this article has been used purely for illustrative purposes and is not a recommendation to buy. You should always seek advice from a suitably qualified financial adviser about whether an investment trust is suitable for you.

Neil Mumford is a Chartered Financial Planner and principal director of Milestone Wealth Management. He has been advising clients for more than 25 years and holds some of the industry’s leading investment retirement qualifications. He specialises in retirement and estate planning, with an emphasis on income strategies post-retirement.