Investing for a comfortable retirement

As featured in this month’s magazine.

The pension freedoms that came into force in April have resulted in a massive change to the way that people finance their retirement. Data from the Association of British Insurers shows that in the first six months under the new rules a total of £2.85bn was invested in income drawdown products. This was comfortably ahead of the £2.17bn that was used to buy annuities.

Retirees who opt for income drawdown can leave their pension fund invested and take out whatever income they want as and when they need it. They keep full control of their capital, which is a big advantage compared to an annuity, but it can be difficult to know how much it is safe to spend, especially given the ongoing market risk.

Most people who find themselves in this position will want an investment that offers a competitive and reliable source of income with a relatively low level of risk to their capital. The obvious solution is a high yielding multi-asset fund where the diversification reduces the volatility below that of the equity market.

Multi-asset funds reduce the risk by spreading the money across shares, bonds and property. This allows the managers to increase the diversification of their portfolios while also looking to achieve a decent yield.

New options

Investment management groups have been quick to spot the opportunity and have created around 60 new multi-asset funds in the six months to the end of September. A recent example is Jupiter Enhanced Distribution, which has an estimated yield of 4% with monthly income and the prospect of long-term capital growth.

The fund operates in the Investment Association’s Mixed Investment 20% to 60% Shares sector and currently has 40% in equities with the rest in bonds. It launched in September and is still really small with just £10m in assets under management.

Another recent addition is the Rathbone Strategic Income Portfolio, which operates in the unclassified sector where the managers have more freedom to alter the asset allocation. It was created on 1st October and aims to generate a long-term total return of CPI inflation plus 3% to 5% per annum as measured over a minimum period of five years, subject to a targeted minimum annual yield of 3%. The volatility is intended to be two-thirds or less of the MSCI World Index over a rolling three-year period.

The Aviva Investors Multi-Strategy Target Income fund was launched in December 2014 and has one of the most complex mandates available to retail investors. It aims to generate a target annual income yield of 4% above the Bank of England base rate in all market conditions with monthly distributions. The four-man management team also seeks to preserve capital while keeping the volatility to less than half of that of global equities over rolling three-year periods.

In order to achieve this threefold objective, the managers make extensive use of a range of derivatives with one of the strategies being to write out-of-the-money options in return for the upfront premiums. The fund has had a fairly quiet start with a 10-month return of 4.31%, of which 2.86% was distributed by way of income.

Tried and tested

Some of the more established funds can also fulfil a similar role in an income drawdown portfolio. A good example is Henderson Cautious Managed, which was launched in February 2003 and operates in the Mixed Investment 20% to 60% Shares sector. It doesn’t target a specific yield, but simply aims to provide income and long-term capital growth.

The fund has just over £2bn in assets under management and is fairly defensively positioned with 52.7% in equities, 34.5% in bonds and 12.8% in cash. It has returned 31.3% over the last five years, which puts it 19^th out of the 143 funds in the sector and has a historic yield of 3%.

Ethical investors may prefer the Eden Tree Higher Income fund, which can take on more risk as it is in the Mixed Investment 40-85% Shares sector. The fund aims to provide an above average and growing income with long-term capital growth.

EdenTree uses an ethical screen and will only invest in companies with sustainable environmental, social and governance policies. Their Higher Income fund was launched in November 1994 and over the last five years has returned 31.2%. This puts it towards the lower end of the sector, but its main emphasis is the income and at 4.5% it has a higher yield than any of its peer group.

The Premier Multi-Asset Distribution fund aims to pay an attractive rising quarterly income with long-term capital growth. It invests between 20% and 60% in equities with at least 30% in fixed income, with the money going into externally managed funds rather than individual shares and bonds.

Someone who invested £10,000 in 2010/11 would have received income of £478 during the first year, with successive annual distributions of £501, £466, £517 and £518. This is a pretty good return and reasonably consistent, which is important if you are relying on it to pay your monthly cost of living. The Premier Multi-Asset Distribution fund was the second best performer in the sector over the last five years with a total return of 48.2%.

Premier also runs the Premier Multi-Asset Monthly Income fund, which has returned 47.6% over five years. This pays out every month with the annual income from a £10,000 investment starting in 2010/11 being £392, £534, £508, £582 and £540. Multi-asset funds are interesting products, but have higher than normal ongoing charges in excess of 2% due to the fact that they invest in other funds.

Investment trusts

One of the main limitations with open-ended funds is that they have to distribute all of their income during their financial year. This means that the annual income will tend to fluctuate and could be higher one year than the next, as was the case with the two Premier Multi-Asset funds. Retirees who rely on the distributions could find this quite a challenge.

UK domiciled investment trusts have more flexibility as they can transfer up to 15% of their annual income to their revenue reserves. They can then use the money to smooth the dividends so that investors are able to enjoy a steadily increasing level of income. Investment trusts domiciled offshore can transfer as much as they want as they are not subject to the 15% upper limit.

Many of these funds have made good use of this feature and increased their payments every year for decades. Even during World War One over a third of the sector was able to grow or maintain its dividends through what was the worst financial crisis in memory.

A good example is the Merchants Trust (MRCH), which has paid higher dividends to its shareholders each year for the last 33 years. Over the last ten years the total annual distribution has increased from 18.9 pence per share to 23.8 pence. It has also produced an impressive capital gain with the shares up 83%.

One fund that has been designed specifically with the income drawdown market in mind is BlackRock Income Strategies Trust (BIST). It was previously known as the British Assets Trust, but the mandate was changed at the end of February with the management switching from Foreign & Colonial to BlackRock.

The fund’s new objective is to target a total return of CPI inflation plus 4% gross per annum over a market cycle of five to seven years. The intention is to grow the dividend at least in line with inflation over the medium term and there is also a clear focus on capital preservation.

BlackRock Income Strategies has 64.9% invested in equities, with 18.1% in fixed income and the remaining 17% in cash alternatives. The shares are currently yielding 5.01% with quarterly distributions and they are up about 6% since the change.

Income drawdown sounds like an attractive option, but retirees who spend too much out of their pension fund could run out of money early. They also have to protect their capital against the impact of inflation, which normally means having some exposure to share prices and leaves them open to the risk of a capital loss.

The new pension freedoms have made it possible for people with relatively modest savings to leave their money invested rather than using it to buy an annuity. Many retirees have taken advantage of the new rules, but these are early days for income drawdown and it remains to be seen whether the funds are up to the challenge.