FOOL'S EYE VIEW
Investing for Income

By Stephen Bland (TMFPyad)
August 20, 2001

This theme is one of my favourite general investment areas. Although a lot of articles on this topic are directed for obvious reasons at the retired, in my experience with many of my own clients over a very long period there are quite a few younger people out there who may also be looking for income-producing investments, for various reasons.

There are two main questions to consider for someone expecting to derive an income over several decades from a lump sum. First in order of importance is security. It is vital that no excessive risks are taken with the investments, whatever is chosen as the vehicle. Second comes inflation. For anyone looking at drawing an income for several decades, inflation is going to make a severe dent in the real value of that income unless some steps are taken to try and counter it.

If very serious amounts of capital are involved, let's say a million and higher, then assuming the person needs only £20,000 per year to live on and the capital is sufficient to produce say £50,000 per year, some might argue that inflation is never going to be a problem since the income is so much higher than the needs anyway, even over a very long period, and the excess can be reinvested. My answer is that you cannot know what might happen over very long periods. So with any income proposal I would always counsel that some way of maintaining the real value of the income is built into the solution.

The most secure way of deriving an inflation-protected income is through index-linked gilts. The start yield is very low but in return for that you get the security of a gilt -- the safest investment that exists in the UK -- with both capital and income linked to the retail price index. This investment ranks above all others in quality, it is absolutely unbeatable, but the big drawback is the very low start income.

Once you consider a higher initial income with the added attraction of potential protection against inflation, then you have to accept a move into risk territory. There are numerous types of investment that provide an income that is both decent at the outset and has the potential to grow with inflation or maybe even more if you are lucky. Some obvious examples include letting property, equity income funds and individual shares.

Property can be attractive in the right location, more so if there is enough money to buy several properties. The risks of having just one may be too high for a someone looking for as secure an income commensurate with inflation protection as possible. Residential property in most of London, my back yard, has in general been a pretty good investment over the years, providing good capital growth with often attractive rental income.

The downsides of residential property are clear. Sheer hassle is one thing. Also, the income can be erratic due to void periods and the incidence of big repair bills that can crop up. This is why having only one is a little bit chancy for someone absolutely reliant on the income.

Equity income funds have several attractions in my view, the obvious feature being that you automatically achieve a good spread of income investments with just one sum. Clearly, though, they extract charges from you, typically with unit trusts something like a 5% initial spread and maybe 1.25% annual. Despite this I consider a few of these to be very good long-term income investments. Many of them have exceptionally good capital performance over long periods in addition to delivering a rising income. The risks are there though, as with any equity investment. Look for consistent past performance of both capital and income; past performance does matter here, in my opinion.

My personal favourite amongst equity income investments though is not funds but a portfolio of direct holdings. I won't go into it much now because I have said it all before and the details are on our high yield message board and my occasional articles updating the 15-share eternity portfolio that I put together last year as an example of how to invest for income in this way. It offers several attractions over funds, specifically no charges and the chance to control your investments yourself rather than be at the mercy of fund managers, for those of a mind to do this.

Finally, I advocate that investors avoid insurance company internal products. My experience of these is that they deliver poor performance. An equity unit or investment trust is far better in my view than something like an insurance company maximum income "bond", for those that wish to invest in pooled products.

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