Gap in the market

Steve wants to know if he can do something better with the lump sum than park it in the best – ie, least worst – savings account. He believes annuity rates are absolutely useless – though more of that in a moment – and he is aware that there is this esoteric thing called ‘the stock market’, which may be more promising. He knows that companies pay dividends, which tend to grow rather than to shrink, and that the ‘interest rate’ on these dividends compares nicely with interest rates that hover just above zero. So what’s to do?

The argument against annuities is more nuanced than popular perception allows. As the table (top right) shows, for a 65-year-old man picking up a 5.1 per cent yield on a plain-vanilla annuity is worth a second thought. True, the arguments against are familiar enough – the income will be eroded by inflation and the capital is written off up-front (obviously). But for a no-worry, no-effort solution – except the misery of dealing with intermediaries and life companies – buying a basic annuity has merits.

Look at it this way, that 5.1 per cent plain-vanilla return compares well with what equities have produced – the total return (capital gains and income) from the FTSE All-Share index has averaged 5.6 per cent a year for the 17 years of this century. Yet that average has been subject to huge volatility. Delivering the income that equates to a 5.6 per cent return without any variation would require digging into capital every year. That might be acceptable since the capital is there to be consumed in the long run. But using extra in the heavily lossmaking years brings the danger of creating a downward spiral where too much capital is used and there is insufficient left to generate the required income in the future.

However, one thing does look clear – avoid an inflation-linked annuity even if its payouts are tied to changes in the Retail Prices Index (RPI). Assume that an RPI-linked annuity rises at 3 per cent a year and it would still take 24 years before it had generated more income than a fixed-rate product at 5.1 per cent. Generally speaking, 65-year-old men can’t wait that long.

Which brings us onto equities. The obvious solution is for Steve to buy a low-cost exchange-traded fund (ETF) that tracks the FTSE 100 index; say, iShares Core FTSE 100 (ISF), which distributes quarterly. That’s useful, but the starting yield of 3.7 per cent (see table) is well short of what’s offered by the fixed-rate annuity. Assume that dividends rise by 4 per cent a year, then it is still 16 years before the Footsie fund has distributed more than the annuity.

True, choosing the stock market route brings the important benefit of having the use of the capital. Maybe Steve wants to use that as a bequest or to cover expensive end-of-life care. Yet there is plenty of equity in Steve’s home that could meet those requirements. In which case, the capital invested in the ETF could be amortised over a sensible period – at least 20 years – using a sum-of-the-years formula to keep the cash received (both income and capital) fairly constant. As the value of the residual capital will swing to the market’s movements, estimating the extra yield is imprecise. But amortising capital is going to add at least an extra half percentage point to the annual return, bringing the starting yield to 4.2 per cent and the break-even period to 10 years.

Yet the break-even period can be eliminated. If Steve compiled a mini portfolio, equally weighted, of the Footsie’s 10 highest-yielding stocks, he would start off with a 6.6 per cent yield from dividends covered 1.7 times by earnings. If that sounds too risky, he could always opt for size and buy equally-weighted holdings of the 10 biggest companies. The starting yield is lower at 4.8 per cent and – surprisingly – so is the dividend cover, but the size of these Footsie giants may offer some defensive merits.

There are other ways to meet Steve’s challenge. High-yield equity funds will do a job, though at a higher cost; and a DIY solution is possible, but that’s not for stock market novices. What’s miserable is that – so far as I know – among the proliferation of ETFs there is nothing that meets an increasingly common need such as this. Pity.