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Four pitfalls of income investing for retirement

26 October 2014

Old Mutual’s multimanager team reveals four of the most important considerations when investing for income during retirement.

By Daniel Lanyon,

Reporter, FE Trustnet

UK demographics are rapidly changing. Not only is life expectancy increasing rapidly but the number of people in retirement is expected to balloon with many spending as long in retirement as they will have done in employment.

The percentage of over 65s is projected to almost double by 2060, according to the International Longevity Centre UK.

The popularity among investors of pensionable age for income is therefore set to hugely increase, with many relying on regular dividends from investments for income to maintain their lifestyles or pay for care due to the demographic trend of an ageing population and increasing life expectancy.

Here Old Mutual’s multimanager team reveals some of the key risks that investors should consider when investing for an income in retirement.


Longevity risk

This is the classic retirement risk – that you actually run out of money in retirement, according to Old Mutual’s Owain Kember.

“You exhaust the pension pot. We have had a decade-long increase of life expectancy in the UK. It means you need to expect more from your pension over time, that’s where annuities got it right,” he said.


Inflation risk

Despite low inflation of late, Kember says on a 10-year view a cash pension pot will be reduced by a third and by 50 per cent over 20 years.

“Investors should look beyond equity income and look at things like commercial property or infrastructure as there is one thing that these asset classes have in common: their underlying cash flows are typically linked to inflation so they are a perfect inflation hedge.”

Investors can access commercial property through a range of funds in the IMA Property sector, although to use as a hedge against UK inflation a fund that has a high weighting to the UK would be the most obvious.

Nine funds in the sector have more than 80 per cent exposure to domestic asset: the F&C UK Property, Henderson UK Property, Ignis UK Property, M&G Property Portfolio, Old Mutual Property, Scot Widows UK Property, SWIP Property Trust, Threadneedle UK Property and TM Hearthstone UK Residential Property funds.

Over the past five years the best performing fund has been Henderson UK Property, which has returned 49.37 per cent compared to an average return in the sector of 39.55 per cent.

Performance of fund and sector over 5yrs

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Source: FE Analytics


Investors can also access infrastructure exposure through several open-ended funds.

However, the Canlife Global Infrastructure, First State Global Listed Infrastructure, Invesco Asia Infrastructure and Macquarie Global Infrastructure Securities are all non UK-specific.

However, First State Global Listed Infrastructure has been one of the best funds in the IMA Global sector for income over the past three years, according to FE Research’s unique way to analyse income funds.

Several investment trusts have high exposure to UK infrastructure including GCP Infrastructure, John Laing Infrastructure and Amber Infrastructure, which all have more than two-thirds of their portfolios in the UK.


Income risk

Kember says another risk is if the stream of income is interrupted, especially if a large part of it is derived from equities. Cash is unlikely to offer a return for some time due to low interest rates and gilt yields are low at just over 2 per cent.

“Income streams from equity income are notoriously volatile. You only need to look back to the recent past of 2007/8. The banks were fantastic dividend compounders over time and then they had to slash their dividends to next to nothing in order to repair their balance sheets.”

“Look at BP, yet another court case has cast a shadow over its ability to pay a dividend and if you look at the disastrous announcement about Tesco’s mis-stating of profits. Plus, even before then they had slashed the profit to focus on capital expenditure.”

The sentiment is echoed by Standard Life’s Thomas Moore, who warned last week that investors in UK equity income funds may be at risk from a few key stocks, including BP, cutting their dividends.

“You might want to look at super-prime commercial property in London instead. It will give you a considerable yield pick-up versus gilts but also it might be an equivalent credit quality to bonds given the credit quality of some western governments,” Kember said.


Capital erosion

The final risk, Kember says, is that investors lose their capital due to market falls, which he says can be avoided entirely by using tactical asset allocation.

“It stands to reason that if you burn your capital you are prejudicing future income flows. You need that capital to remain constant for as long as possible, if not to increase, in order to generate future income, especially given the extended lengths of peoples' retirements.”

“Some managers have come out in the press recently to say that you might be OK to start selling down your capital to meet an increasing shortfall in income. That is a very risky strategy in retirement.”

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Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.