The attractions of investment trusts for income: Neil Mumford

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 for clients as a source of retirement income?

Investment 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’ investment trusts should be considered 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, 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. This is 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 9 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.

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.