When it comes to generating income from your investment portfolio, the essential element is striking the right balance between keeping the value of your capital intact and providing for withdrawals in the form of a regular income.

It is for the investor to decide how much risk to take, and this itself will depend on the reasons why you need the income and when you want to take it. Some risk to capital may be acceptable for a certain period of time and at certain stages of your personal investment cycle. At other times, for example when approaching or actually in retirement â“ when income needs may be more stable â“ risk to capital will not be so acceptable.

In this context, it is useful to gauge the views of key fund managers on the prospects for higher-income investments and which areas you should perhaps be focusing on. You should also seek guidance from a suitably qualified independent financial adviser (IFA), who can provide recommendations for building an income-producing investment portfolio, both now and in the future.

Prospects for higher income

Considering the outlook for generating higher levels of income in the current market and what returns are achievable while protecting capital, the prospects would seem to be good. The income message is a positive one, according to Graham Ashby, manager of the Sarasin International Equity Income Fund and the Sarasin UK Equity Income Fund, and is based on the dividend yield generated by shares.

‘Despite the rally over the last few years, current yields on equities still look attractive relative to many other asset classes,’ he says. ‘However, unlike other asset classes, equities offer the potential for dividend growth. This means that they can act as a hedge against a pick-up in inflation, as this will allow many companies to increase prices, improve profits and so pay out higher dividends.

‘Although companies have increased dividends in recent years, they have, in most cases, failed to keep pace with the significant improvement in earnings,’ Ashby continues. ‘As a result, dividend payout ratios are at very low levels. Combined with strong balance sheets and increased shareholder pressure to return cash to shareholders, the prospects for dividend growth worldwide are very strong â“ I would say at least ten per cent per annum.’

He concludes, ‘This combination of an attractive yield and strong dividend growth is a very powerful one for investors, and should help equity income funds to produce good absolute and relative performance in the coming years.’

Geographical focus

Balance is key to any investment portfolio: not only holding a range of different investments but also varying where each invests. When selecting investment funds and management houses, establishing a balance across geographical and business sectors is key.

Sven Kuhlbrodt, marketing director at J O Hambro Capital Management argues that the idea of sourcing your income globally is proving increasingly attractive. While he says the J O Hambro UK Equity Income Fund invests solely in UK quoted companies, he also points out that the UK market is very diverse, with around 60 per cent of total earnings derived from overseas markets.

‘Two examples of overseas themes we are trying to capture in the portfolio are the recovery in European (ex. UK) economic growth and capital upside in Eastern European property,’ says Kuhlbrodt. ‘In terms of the former, it is interesting to note that, for the first time in ten years, German GDP growth is likely to exceed that of the US this year.’

He adds, ‘Stocks we own that will benefit from this are DS Smith and Electrocomponents. Eastern European property is also attractive. As these countries join the EU, property yields are falling. As well as offering good dividend yields, around five to eight per cent, we think these stocks offer significant capital upside. Examples of stocks in this area are Atlas Estates and Dawnay, Day Carpathian.’

Sector focus

It is also important to see which business sectors fund managers are focusing on. Simon Nichols, alternate manager on the Newton Higher Income Fund, has a strict yield discipline, which guides him to areas of the market where the yield available on stocks is higher than that of the overall market.

‘We have started to see value in the pharmaceutical sector, whereas 12 months ago we would not have had any exposure,’ he says. ‘Conversely, in the past we owned a number of real estate stocks. However, strong capital performance has resulted in these being sold, as they now trade on low yields relative to the market. We look for sustainable and growing dividends, so tend not to own stocks where earnings or valuations have been artificially inflated by recent trends.’

Kuhlbrodt highlights the UK banking sector, where he says valuations seem to be assuming a significant deterioration in consumer credit quality, which does not look likely.

‘Banks, such as Barclays and HBOS, have already experienced a material deterioration in their consumer credit card/unsecured lending operations and yet are still showing double-digit earnings growth,’ he says. ‘We believe this reflects their diversification, both by geography and product, which is not reflected in somewhat miserly ratings. Recent data and comments from banks suggest that credit quality is actually stabilising. We continue to see increasing dividend distributions from most banks.’

Kuhlbrodt says that consensus on the retail sector has also been overcautious. ‘Obviously, interest rates have just risen, but we think inflation will fall quickly during the next six months, as lower utility prices feed through. This could mean that interest rates have reached a peak,’ he says.

What the advisers suggest

So how do you get the right balance in your investments to get to the income you want? Amanda Davidson, director of IFA firm Baigrie Davies, estimates that for someone wanting to retire now, for example, to achieve about £20,000 in income each year, around £400,000 is needed as capital invested (see Table 1, below). And for someone planning to retire in about five years’ time, the capital they should be looking at now to grow to £400,000 in five years’ time should (note the “should”) be sufficient to produce the £20,000 income per annum (Table 2).


In Table 1, the total income does not quite round up to £20,000, and Davidson explains where the £2,200 balance is to come from: ‘It would be easy to put the whole lot in a bond where the income is guaranteed never to go below five per cent per annum, but I would not recommend that for this sum,’ she says. ‘You could also choose only fixed-interest funds and easily get to the desired income level. But this would have been a poor asset allocation choice and would allow for little, if any, growth to provide some inflation-proofing to the income. So the balance “income” must come from encashment of some capital.’

Davidson says it can be easy to get a bit hooked up on the labels “capital” and “income”. ‘The important thing is for the portfolio to produce a total return that justifies and enables the desired level of “income” to be taken,’ she says. ‘It is a generalisation, but the greater the yield the smaller the capital growth expected. At extreme levels â“ for example, we have a fund in with a 7.7 per cent level of income â“ there may be no capital growth or even capital loss. Therefore, I would look to take the extra £2,200 needed from the lower-yielding funds, assuming the investment market was right.’

On the perennial debate about whether one should invest in the stock market, Davidson says that, of course, a portion needs to be in equities. ‘This is where real growth, i.e. growth that beats inflation, would be expected,’ she says. ‘Investors often see retirement as a finishing point and think they should choose safer funds from then on. While I agree that taking unnecessary risks would not be sensible, someone retiring at, say, 60 or 65 and looking to generate income from their portfolios can expect to live 20 years or possibly more. This timeframe lends itself to equities, and short-term volatility can be evened out by using property and fixed-interest funds.’

All the funds Davidson has selected in the portfolios shown in Tables 1 and 2 are OBSR rated, but she points out that the asset allocation is much more important in ensuring a healthy ongoing portfolio.

Ian Roberts, director of IFA firm ARW Partnership, points out that to achieve an income of £20,000, a significant level of capital protection is required. His portfolio recommendation for achieving income in retirement (Table 3) is based on a level of withdrawal of seven per cent per annum, which would require a minimum level of capital of £330,000.

‘At present, this portfolio is low on fixed-interest (bonds) due to the current uncertainty over interest rates,’ says Roberts. ‘Property is used as a diversifying asset, with returns for the next 12 months projected to be between seven and nine per cent.

‘Other considerations for capital protection would be to consider the Hartford SafetyNet, with the investment in one of its Gold Portfolios, or the Close Brothers Escalator Funds, which give the option of 100 per cent capital protection with stock market-linked gains.’

When it comes to preparing to generate a £20,000 income in five years’ time, Roberts estimates that to produce the required capital amount of £330,000, an initial capital sum of £240,000 would be needed now, with an annual growth rate of seven per cent throughout the five years. As an alternative to the asset allocation he recommends in Table 4, Roberts also suggests consideration should be given to the Skandia Global Best Ideas Fund or the multi-asseted Midas funds.

Coping with inflation

If, however, on retirement you want to avoid purchasing an annuity and intend to draw down income from your fund using an unsecured pension, an entirely different approach needs to be considered. ‘We would recommend a portfolio with exposure to the four main asset classes â“ equities, bonds, property and cash,’ says Alan.

Smith of IFA firm Capital Asset Management. ‘We would suggest allocating sufficient funds to cover the first two to three years’ income to cash. Equities and property are “real assets” and are necessary to ensure that capital growth and income can keep up with inflation, which would otherwise significantly erode pension income over time.’

Smith presents the following possible portfolio, also estimating that approximately £400,000 would be needed to generate £20,000 gross per annum. Bonds, he says, are held as a hedge against volatility in the equity markets due to their inverse correlation with the global stock markets, as well as the secure income yield available.

Smith suggests 40 per cent invested in equities, and highlights Artemis High Income and Invesco Perpetual Income as potential funds to invest in; then 20 per cent in property, such as Standard Life Select Property or New Star Global Property; 30 per cent in bonds, for example in AEGON Fixed Interest or Old Mutual Corporate Bond; and the final ten per cent in cash, in a fund such as Investec Cash.

This article is from the June 2007 issue of What Investment, on sale 26 May 2007.