Investing Basics: Generating an income from investments

Generating an income has been an increasingly important objective for many investors. The income available from conventional savings accounts has dwindled to near-zero at a time when changes to the pension rules have set more retirees in search of income-generative investments to replace an annuity income stream.

Plenty of investments advertise a high income, or a growing income, but what do investors need to bear in mind in the selection of income investments?

Investment income tends to come from two main sources: dividends from shares and interest payments from bonds.

Each type of income has different characteristics – dividends from shares tend to be better at mitigating the erosive effects of inflation but share prices can be volatile and subject to large price movements.

Bonds are effectively loans to a company or government which are issued with a promise to pay the money back at a fixed time along with interest at a fixed rate.

They are often considered to be at the lower end of the risk spectrum but the potential for returns is usually considered to be lower too. Interest payments from bonds, also known as coupons, have historically proved more consistent than dividends from shares.

As such, holding a blend of income sources in a portfolio can offer greater consistency over time.

‘Investment income tends to come from two main sources: dividends from shares and interest payments from bonds’

From there, it is tempting simply to pick the highest income available, but this approach can have a number of limitations. First and foremost, a high yield may be a sign of distress.

At a time when the income available on cash savings is negligible, an investment paying 7-8% is likely to be taking a lot of risk to achieve that income.

It may be invested in companies that are having problems, where there is an expectation that the dividend will be cut, or there might be a default on the bonds. Investors may want to consider how an income is being generated.

Equally, the income may be artificial – in other words, it may have been increased using complex financial instruments, such as derivatives whose values are derived from another underlying asset e.g. shares.

Fund managers can use complex instruments to raise the income level of the fund when the assets fail to produce it naturally through dividends and coupons.

This is a valid strategy, but can mean higher risk and comes at the cost of sacrificing some of the potential returns when the assets are doing well.

For investors who want to preserve the purchasing power of their long-term savings – to pay care home fees, for example or leave a legacy to their family – this may be an issue.

As such, for most investors an investment generating a natural yield, rather than artificial one, from a blended portfolio might be more appropriate.

The yield (also known as income) should be high enough to mitigate inflation and, ideally, should also exhibit some growth.

The importance of growth in income is often neglected, but for a retiree with potentially 20-30 years of retirement ahead of them, growth in their income will be vital.

Assuming an annual inflation rate of 2% (the Bank of England’s target rate), an income of £10,000 in 1990 would have needed to rise to over £17,000 today to have the same purchasing power; the current spike in inflation in which we are being warned to prepare for a rate of 10% or more makes this an even bigger ask.

This also highlights the importance of taking a long term view on investing so that time smooths out what will hopefully be short-term fluctuations.

In practice, an income investor might buy a portfolio of shares and bonds for £1000 paying an annual income of £4. An investor in retirement needs that income to grow in line with inflation. In other words, that investor needs to get £4 in the first year, then, say, £4.25 the next, and then £4.50 the next, to ensure that their purchasing power is maintained over time.

‘an income of £10,000 in 1990 would have needed to rise to over £17,000 today to have the same purchasing power.’

There are also administrative considerations in how investors structure their income. Many funds have income and accumulation units. The income units pay out the income generated by the fund, while for accumulation units, this is simply added back into the fund.

Many platforms/online brokers will then also offer investors the option of reinvesting their income units. This can be useful if investors want to switch on and switch off their income stream as and when they need it.

There may be cost implications involved in reinvesting rather than using accumulation units, but this will depend on the individual platforms. Nevertheless, investors should understand the differences.

There will also be differences in the way fund managers take their charges. Some will take charges out of the fund’s capital and some out of the income generated. For income investors, charges can act as a drag on their income returns.

Funds also vary in the way they pay income. Some will pay monthly, some quarterly, some semi-annually and some annually. The right option will depend on investor preference, but many looking to supplement income generated elsewhere may like regularity of income. There may also be an impact on performance from the different options, depending on market conditions.

For all income investors, there will be tax considerations if the money received from investments exceeds their annual personal allowance (£12,570 for the 2022/23 tax year) and is held outside a Stocks and Shares ISA**.

Income investors could avoid this by sheltering as much as possible within an ISA wrapper, where all income received is tax-free. ISA allowances are relatively generous at £20,000 for the 2022/23 tax year.

Investors looking to generate an income from their investments have a range of factors to consider in building a robust and reliable income-generative portfolio. They need to consider the assets that they would like to incorporate, how much risk they are willing to take to achieve an income and importantly, they should try to ensure that the income offers some mitigation against the damaging impact of inflation.

** This is based on current tax rules which are subject to change in the future.