VALUE INVESTING
Retirement Investing For Income: The Basics

By Stephen Bland (TMFPyad)
August 1, 2003

This week's article is not really about value shares directly, more about retirement investing for income. I have in mind a person in possession of a sizeable lump sum, maybe well into six figures, who no longer has an income from employment or business and who therefore needs to live wholly or partly upon investment income.

The source of the lump sum could be varied. Amongst the most common will be selling the home and moving to a cheaper one, another will be inheritance. Whatever, the reasons as to how this lump sum came into existence are not important for my purposes here.

One point I must stress: income investors (in fact all investors in my view) should avoid investment products from an insurance company. Too many scandals, disasters and generally poorly performing products, often marketed with breathtaking cynicism amid expensive ad campaigns. As an example relevant to this article, witness the very high headline rate that income 'bonds' promoted not so long ago where the capital was at extreme risk. They were aimed at the very people least able to afford loss of capital: the retired, desperate for more income after bank deposit rates had collapsed over the last few years.

The majority of investment questions start with the level of risk acceptable to the investor. It is no use advocating a high yield share portfolio to someone who could not live with the volatility, nor suggesting a gilt portfolio to someone who actually desires the potential risks and rewards of equities, nor a buy-to-let property for someone who just does not want any hassles.

Generally I see three main options for income where the capital is retained by the investor: equities, fixed interest and property. Each has subdivisions. Equities can be either direct shareholdings or funds. Fixed interest includes gilts and corporate bonds, convertibles and preference shares. Gilts can be split into dated, both level and index linked, or undated. Property can be residential or commercial. Each of these has a different risk profile.

The most secure investment of all these examples, by a very long way, is gilts, British government loan stocks. By secure I mean the risk of default on capital or income. If such security is crucial to you above all else, then some combination of the many types of gilt available is probably the answer. Of course, in return for this security, you have to accept a modest income, somewhere between 2% and almost 5% at present, the lower figure arises on index-linked stocks whilst the higher is on undated stocks. In between, there is a range of dated gilts with varying rates and redemption dates. The wide variety of gilts on offer means that with a large lump sum, a gilt portfolio with a range of types and dates could be constructed to meet particular individual requirements. Corporate bonds and preference shares will generally offer a higher interest rate, depending on the quality of the issuer, because their security is inferior to that of the government.

Way below the security of gilts comes equities. The high yield portfolio (HYP) idea about which I write is an example of investing in a fixed portfolio of fifteen shares and then taking a position of positive inactivity, receiving the dividends for income. The only decisions to be made are in the initial selections and the occasional subsequent event necessitating some action. Readers interested in this can look at the HYP board and these articles for further information. Shares involve risk to both capital and income in order to try and achieve long-term growth in both, so this route is only for those prepared to live with that. I believe though that a diversified portfolio is not as risky as some would have it. The capital fluctuations do not matter much to a perpetual income investor and the dividend income, though obviously volatile to a certain extent, is not likely to be hugely so. In my HYP1, which will be three years old in November, the income in year two was fractionally up on year one whilst year three is likely to be down slightly on year one.

As an alternative to direct shareholdings, many equity income funds are available but you need to be selective, not all have good long-term results.

Property has some definite investment attractions in my opinion, but also risks and possible trouble too. It cannot be denied that in many cases residential property in particular has been a good way to derive an income for many years by letting whilst enjoying substantial capital growth too. But it is not for everyone; there can be problems with tenants and the building. I have known people go very wrong. It has become so popular that some believe that we have now reached 'shoeshine' in rented property, particularly in London, causing falling rents and maybe capital values in due course. That may well be so. Bubbles exist in rented property as elsewhere, I've seen it all before, but I believe that to be temporary and in my view the long-term outlook remains good.

None of the above options are mutually exclusive of course and for many income investors, a mix of these may be the best route. I suspect that only a minority will consider property because of the potential troubles and because it involves too much in one single holding, unless you have a sufficiently large lump sum to invest in a portfolio of properties.

My personal preference for income investing with a large lump sum whilst maintaining an easy hassle-free life would be a mix of various gilts according to age and circumstances and an HYP, the proportions depending on risk profile ranging from 100% gilts to 100% HYP.

Clearly a short article like this must be limited to a few general suggestions. Individual circumstances will always dictate the individual solution to any income or other investment question.