Why investment companies work so well for investors in drawdown
David Prosser looks at why investment companies have an important role to play in savers’ retirement portfolios
There was a time when investors reaching retirement age typically had simple needs – they needed financial advice on the best type of annuity to convert their pension fund savings into regular income, and analysis of who paid the best rates. These days, with the majority of investors opting to draw retirement income directly from their pension funds, rather than to buy an annuity, the conversation is more complex – and the need for advice is ongoing.
Still, when it comes to restructuring the pension fund of an investor moving into an income drawdown arrangement, there is one way forward for advisers that stands out as a particularly strong option. Investment companies make highly attractive drawdown fund holdings.
There are two reasons for this. First, the premise of drawdown is that assets left invested will continue to rise in value over time, providing the basis for additional pension income later in retirement (or even for bequests to heirs). Since investment companies have a long-term track record of outperforming other types of fund on investment growth, this makes them strong candidates for inclusion in drawdown portfolios.
Perhaps more significantly, however, drawdown investors also need to generate reliable income from their funds. And here, investment companies really come into their own, offering the opportunity to smooth income over time.
Critically, investment companies are uniquely allowed to retain up to 15% of the income they earn on their portfolios each year, rather than having to pay it all out to investors. This enables them to build up dividend reserve funds that can be used to subsidise payments to investors in years when the portfolio has generated disappointing amounts of income.
These days, with the majority of investors opting to draw retirement income directly from their pension funds, rather than to buy an annuity, the conversation is more complex – and the need for advice is ongoing.
David Prosser
The important point here isn’t that investment companies will generate more income for drawdown investors – that may or may not be the case. Rather, the smoothing effect means there is much less chance of a nasty surprise for an investor when it comes to pension income. With reserves to fall back on, investment companies are much less likely to have to cut their pay-outs to investors, even in troubled times.
Indeed, investment companies have an excellent record of raising income distributions each year. There are 20 investment companies that have raised their dividends every year for the past 20 years; a further 28 funds have the same record over at least the past 10 years.
These 50 or so investment companies span most areas of the market, meaning that it should be possible to build a well-diversified portfolio of assets for a drawdown investor from their ranks. That gives investors two types of protection – diversification will mitigate some of the capital risks facing their pension funds, with the dividend reserves offering income security too.
There can be no guarantees – investment company share prices can fall as well as rise, of course. And dividend shocks are always a possibility – though it’s worth pointing out that the funds mentioned above all managed to get through the Covid-19 crisis with their records of annual dividend increases intact.
Overall, however, the takeaway here is that investment companies potentially have a huge role to play in income drawdown planning. They could become the bedrock of many savers’ retirement portfolios.
