A rising and sustainable income

Retirement really should be the holiday of a lifetime. But, even more than is the case with a short summer break, you need sufficient money to make the most of it.

Unfortunately, today’s low interest rates mean large sums of capital are required to produce relatively modest amounts of income.

Fortunately, investment company shareholders enjoy unique advantages over unit trust and exchange traded fund (ETF) investors when seeking a high, rising and sustainable income. Technical but important differences between these three types of pooled funds have helped 21 investment companies to increase income payouts to shareholders every year for more than two decades. Even more impressively, four investment companies have done so for more than 50 years.

The ‘Fab Four’ among these investment company dividend heroes are Alliance Trust, Bankers Investment Trust, Caledonia Investments and City of London Investment Trust. Each has increased dividend distributions every year since 1967. That was when Sandie Shaw won the Eurovision Song Contest with ‘Puppet on a String’ and Prime Minister Harold Wilson announced Britain aimed to join what was then the European Economic Community and is now the European Union.

How did so many investment companies manage to increase income payments to shareholders during decades that saw the bursting of the dot com bubble at the turn of the century, the global credit crisis and interest payments to bank and building society savers plunging to historic lows?

First, investment companies have a unique ability to smooth out some of the shocks of the stock market by retaining up to 15% of dividends in good years to top-up payouts in bad years.

Second, they may supplement dividends with capital gains from their underlying portfolio of assets – a feature introduced six years ago. Neither of these financial shock absorbers is available to people aiming to fund retirement with income from unit trusts, open-ended investment companies (OEICs) or ETFs.

Both could be vital advantages for pensioners if setbacks of any description cause global stock markets to fall from their current all-time highs and lead to dividends being cut or cancelled.

Pensioners are potentially very vulnerable investors because, by definition, they are unlikely to have much earned income. Nor are they likely to be able to put in a bit of overtime to make good the damage done if the stock market plunges by nearly 50% - as it has done twice this century so far.

Of course, the past is not necessarily a guide to the future. But it does provide one factual basis upon which to make forecasts about what might happen in the years ahead.

This raises a third advantage that investment company shareholders - including your humble correspondent - enjoy over most ETFs and many passive unit trusts and OEICs or tracker funds. Most investment companies are actively managed which means professional analysts aim to use stock selection to avoid over-priced shares which have already soared into the indices and to identify bargains which may deliver the best returns in future.

By contrast, tracker funds passively follow indices, most of which are based on stock market capitalisation - or the total value of each company’s shares. So inclusion in most indices is reliant on past performance, which might not continue in the future, and could also cause investors in passive funds to inadvertently follow financial fashion, buying expensive shares and shunning bargains.

That distinction is particularly important for income-seeking investors because out-of-favour shares are most likely to offer higher yields - or the dividends paid to shareholders, expressed as a percentage of the share price. While high yields can sometimes prove to be warnings of trouble to come, active stock selection may also help to identify companies that will deliver rising streams of income in future.

Helpfully, the AIC’s website shows how each investment company has managed to increase dividend distributions in the past. Across all investment companies that are AIC members, the average annual increase in income payments to investors over the last five years is 3.1%.

This happens to precisely match the current annual rate of inflation, as measured by the Consumer Prices Index (CPI), and shows how most investment companies are succeeding in preserving the real value or purchasing power of their shareholders’ income. While there is no guarantee this will be sustained - because share prices may fall and you might get back less than you invest in the stock market - investment companies’ unique structural advantages over other pooled funds may continue to prove important considerations for investors seeking a high, rising and sustainable income.

Ian Cowie is a columnist for The Sunday Times.