Retirees told to focus on income...and not volatility

RETIREES who are using a defined contribution pension plan to help fund their everyday finances are being advised to reappraise how they take money from the scheme – against the backdrop of volatile stock markets and rising interest rates.

A ‘white paper’ just published by income planners Chancery Lane argues that income-hungry retirees need to ensure the investments in their pension plan are ‘sufficiently reliable to meet this single, personal need’.

It argues that too many people in retirement hold investments inside their pension plan on the basis of their ability to generate total return – a mix of capital growth plus income – when the emphasis should be on securing a stable source of income.

Doug Brodie, co-author of the report, says the two sources of return are ‘commonly conflated’ by investors, which, he says, is an error as ‘the capital volatility [of an investment] can hide its income stability’.

If the investments in a pension are chosen on the basis of income dependability, Brodie says, any short-term volatility in share price can be tolerated. This is because the investments do not have to be sold to generate income, so no capital loss need be crystallised.

He says many income-generating investment trusts listed on the London Stock Exchange can deliver retirees this stable income without selling assets held within a pension.

Chancery’s report is important because an increasing number of people are retiring with a defined contribution pension – or a number of them accumulated over their working life – as their main source of income.

Unlike a defined benefit pension, where income is based on a formula built on salary and years worked, a defined contribution plan is more flexible.

Since 2015, retirees have had far greater control over the money in such a plan. They can convert the fund into a stream of lifetime income through the purchase of an annuity – an option made more appealing in recent months as annuity rates have risen in response to higher interest rates and gilt yields.

But many keep their pension fund intact, taking an ‘income’ from it as needed. This income might come from the sale of assets – the conversion of capital into income – or from dividends paid by investments in the plan.

Brodie argues that incomefriendly investment trusts ‘can help provide a stable income to those who have waved a fond farewell to their former safe income – their monthly salary’.

He adds that such an approach ‘may not be sexy, but it is definitely the more reliable boyfriend or girlfriend’. Crucially, it keeps an investor’s pension fund intact. They are not having to create income by selling assets.

Many investment trusts are ideal for income-seekers in retirement because of their ability to pay regular income – usually quarterly – through thick and thin. This is because they are able to dictate what they do with the flow of dividends they receive from the investments they hold (typically UK companies, overseas shares or both).

They can pass them on to shareholders, hold back a little to be paid later, or top up income with drawings from reserves.

Brodie says: ‘Shares in incomefriendly trusts tend to rise and fall in line with underlying holdings. There’s little or no correlation with the stable dividends they pay shareholders – a stability primarily resulting from the use of income reserves.’

The Association of Investment Companies says 46 investment trusts have grown their annual dividends each year for at least the last decade, and 17 for more than 20 years. Trusts such as City of London, Bankers, Alliance and F&C have over 50 years of dividend growth.

By way of example, Chancery looked at how an investor would have fared if they had invested £100,000 in the UK stock market in January 1999 and taken £4,000 of income from the portfolio at the end of each year.

Assuming the sum was invested in a fund tracking the FTSE100 Index, Chancery says they would have ended last year with a £69,552 sum – having enjoyed income totalling £92,000. If they had put the same £100,000 in ‘eight well-established’ trusts, they would have ended up with £214,792 at the end of 2021 and income totalling £161,543.

Brodie says: ‘Baby boomers, born between 1946 and 1964 are being ignored by financial services. The view is they have money so will be fine. But that’s not true. It’s income they need, and the industry needs to do more to help them secure it.’