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Invest in growth for income

Dividend-starved investors can create an income by selling growth investments
May 21, 2020

This year has been dire for equity income investors as companies have slashed dividends in a bid to conserve cash amid the coronavirus pandemic, on top of a drop in oil prices. UK dividend stalwarts such as Royal Dutch Shell (RDSB), HSBC (HSBA), Royal Bank of Scotland (RBS), Lloyds Banking (LLOY) and BT (BT.A) have suspended or reduced their dividend payments. Asset manager Janus Henderson Investors estimates that 36 per cent of all dividends payments in the UK have been cut and a further 9 per cent look vulnerable this year. And globally, the company predicts a worst-case scenario of dividend declines of 35 per cent, with the biggest cuts in the UK and Europe, although it expects that US and Asian dividends will prove to be more resilient. 

The equity sectors that traditionally pay high dividends, such as oil and banking, have also underperformed in recent years.

And dividend cuts mean that equity income funds have less money to pass on to investors, in particular open-ended funds, which can only pay income to investors from the dividends they receive.

“One of the most popular fund sectors for drawdown investors in recent years has been UK Equity Income, but this has frankly been a horrible place to be in more recent times, with many funds not delivering any returns over the past five years,” says James Baxter, head of private client advice at Tideway Investment Group.

According to FE Trustnet, the Investment Association (IA) UK Equity Income sector average total return is -6.4 per cent over five years and -18.7 per cent over one year to 15 May 2020. By contrast, over five years the IA Global sector average total return is 45.4 per cent, and over one year 1.7 per cent.

Investment trusts can retain up to 15 per cent of the income they receive from their holdings every year in revenue reserves. So in years when a trust's holdings do not pay enough income for it to increase or maintain its own dividends, it can supplement this by drawing on the revenue reserve. However, this may not be sustainable and some equity income investment trusts, such as Troy Income & Growth Trust (TIGT), have warned that they may have to cut future dividend payments.

 

Income from growth

Instead of putting money into income-bearing investments, investors looking for a regular income over the long term could hold securities that make a good total return and supplement their income by selling some of their holdings in these. 

Rachel Winter, associate investment director at Killik & Co, says her company's approach for some time has been to invest for growth rather than for income, and if a client needs income to get that from a combination of their investments' natural income and by selling some of their holdings. Ms Winter says that if you want a return of, for example, 5 per cent a year, it is likely that you will need to invest most of your portfolio in equities. This is because getting a decent yield from bonds is now “very difficult”, while commercial property, which used to be a source of income, includes a number of at-risk areas you wouldn’t want to invest in, for example retail and offices.

But the sort of yield you could get from an equity growth portfolio is probably at most about 2 per cent, so if you need more income you may need to sell shares or units in growth investments.   If you are looking to construct such a portfolio, Ms Winter suggests holding global growth funds Fundsmith Equity (GB00B41YBW71) and Scottish Mortgage Investment Trust (SMT). She says that they have attractive long-term prospects because of their exposure to companies that could benefit from permanent lifestyle changes as a result of the current lockdown.

If you avoid just targeting the stocks that pay the highest dividends, you should also end up with a more diversified portfolio in terms of sector and geography. Technology stocks, for example, typically have low dividends, but have been among the best performers over the past decade. They also look well positioned for growth as the measures taken to contain the coronavirus pandemic have accelerated trends such as shopping and buying entertainment online, and remote working. 

If you are less focused on high-yielding equities you could also invest in US, Europe and Asia-listed stocks, which historically have paid lower dividends than UK equities. Most of the large, fast-growing tech companies are listed in the US, while Asia also has some promising long-term investment opportunities. Janus Henderson Investors also notes that two-thirds of the dividends in Asia ex Japan look safe this year.  

Ben Yearsley, director at Shore Financial Planning, says good sources of overseas equity income include Aberdeen Asian Income Fund (AAIF), which was trading at a discount to net asset value (NAV) of 13.3 per cent, as of 15 May. He is a “big fan” of Asia for investors with a long time horizon, and says this trust could deliver both growth and a resilient income.

When selling investments to create an income, you should be flexible about the time when you sell them, so that you can do it at the right time. Working out when to do this is not a precise science, but when you need income consider what looks best to sell on the basis of valuations and earnings estimates. Or sell a bit of all your holdings if doing this won't result in hefty dealing fees. Although a number of investment platforms do not charge for buying and selling open-ended funds, check to see what your platform charges to trade the types of securities you are planning to sell.  

 

Higher risks

Although growth stocks are likely to make stronger returns over the long term than income stocks, they are generally considered to be higher risk. John Betteridge, chief investment officer at wealth manager Rowan Dartington, adds that buying and selling growth stocks for income “can be more difficult than it appears”.

If you hold growth stocks, or funds that invest in them, you should be prepared for your overall returns to be more volatile. You should also have a significant cash reserve of between one and three years of your expenditure to draw on if necessary.  This would mean that you would not have to sell investments when their value has fallen to less than what you paid for them during a bear market. Kay Ingram, chartered financial planner at LEBC Group, suggests that you draw income for essential and discretionary spending from different sources. Income for essential spending should be guaranteed “where possible”, so you can avoid being a forced seller at the bottom of the market.  

Mr Baxter adds that funding withdrawals by selling investments at a loss “completely defeats the object of investing to reap a better long-term return and will rapidly accelerate the decline of your capital”.

Having a portion of your portfolio in non-equity income-generating assets, meanwhile, will supplement your income and diversify your portfolio. As pointed out in The Big Theme in the issue of 7 May ('Don't discount bonds as a source of income, IC, 7 May 2020), bond funds can offer attractive yields with lower volatility than equities. But these expose you to other risks, such as the possibility that a rise in interest rates pushes down bond prices and the difficulty in trading bonds during market stress.

Some alternative assets, such as infrastructure, leasing and property, can also offer attractive yields, and in The Big Theme of 17 April ('Alternative investments for the dividend drought', IC, 17 April 2020) we highlighted a number of funds that look well positioned to maintain payouts. But these funds invest in more esoteric assets, so it is important that you understand what they invest in and are happy to take on the risks they involve.        

You may also need to lower your expectations of real returns – especially as interest rates are at record lows across developed markets. Mr Baxter says that, after fees and inflation, income expectations for investors in drawdown should be “in the 1 per cent to 2 per cent region – not 6 per cent”.

 

Tax efficiency

Selling growth investments to create an income can be tax-efficient. You do not pay tax on dividends from investments or profits from sales of investments, held within tax-efficient wrappers such as individual savings accounts (Isas) and pensions. You can invest up to £20,000 a year in an Isa and take money out of it without incurring tax.

After age 55 you can withdraw up to 25 per cent of your pensions tax-free, although pay income tax on further withdrawals at your marginal rate.  

However, while you can receive dividends worth up to £2,000 a year from investments held outside Isas and pensions tax-free, anything above that is liable to tax. Basic-rate taxpayers pay 7.5 per cent tax on dividends over the annual dividend allowance, higher-rate taxpayers pay 32.5 per cent and additional-rate taxpayers pay 38.1 per cent.

By contrast, if you sell investments held outside Isas and pensions you have a much larger capital gains tax (CGT) allowance, which for the 2020-21 tax year is £12,300. If your overall annual income is below £50,000 you pay tax of 10 per cent on gains in excess of the annual CGT allowance, and if your income is above £50,000 the rate is 20 per cent.    

You can also offset capital losses against gains to reduce your CGT liability. Current market conditions might create such opportunities because certain stocks have experienced sharp price drops in recent months, so if you sell them it may be at a loss. 

So, for example, if you hold stocks or funds within a general investment account that are at a lower price than you bought them for, you could sell them and buy them back within an Isa. You could then offset the losses against future capital gains outside tax-efficient wrappers, if you report them to HM Revenue & Customs within four years.