The changes to the UK pension industry introduced by the chancellor over the past few years have led many investors to consider different ways to take an income from their investment rather than the traditional purchase of an annuity. 
The greater freedom to put their pension pots to work has put more responsibility in the hands of individual retirees and increased the importance of knowing just what they are likely to get from their investment.
One of the most important issues that investors must consider is how they are going to turn their nest-egg, assuming they are lucky enough to have built one over the years, into a regular income. The traditional route to funding one’s retirement is through the purchase of an annuity, which will typically pay a predetermined series of payments for as long as the pensioner remains alive.
While this ensures that income is received for the rest of the retiree’s life, the current low level of government bond yields has weighed on annuity rates and depressed the returns available, reducing the appeal of annuities to many investors.
Instead, people may choose to take cash from their pension pot and invest it in income-producing assets. This involves the consideration of how much risk an individual is prepared to accept from his or her investment.
In general, the higher the potential return from an investment, the greater the risk that the return does not turn out as desired. Therefore, investors who are tempted to put their money into investments offering eye-catching yields run the risk of being disappointed and seeing their capital deteriorate.
Ideally, investors would generate sufficient income from their investment to keep pace with inflation without depleting their pot too soon, while also leaving some capital to pass on to their families.
According to their needs and aspirations, investors might be best served by taking an approach that avoids drawing from their capital altogether. They could in fact attempt to grow the capital value of their cash pot by investing in a broad range of income-paying assets and targeting a prudent but achievable return from this growing capital base.
In this way, investors are likely to have the best chance of potentially growing their nest-egg indefinitely, thereby avoiding the need to identify a period of time they can expect their money to last.
Also, aiming for a deliberately conservative level of return avoids having to invest in higher yielding and potentially riskier assets that could jeopardise the capital base and the level of income expected to be received. It is important to recognise that a steady income from a growing capital base will generate superior returns over time than a higher yield from a static or shrinking capital base, as shown below.
The importance of capital growth on income
Source: M&G, September 2015. For illustrative purposes only.
After analysing more than 20 years of market data, it appears that aiming for a yield of 4 per cent, before tax, is a suitable level that could potentially be maintained over time, while also offering the prospect of capital growth.
However, this level of return can never be guaranteed and depends on the varying returns from those income-paying assets held in a portfolio, such as dividend-paying shares and bonds issued by governments and companies. It will also vary with the decisions taken on how to allocate the portfolio between the different asset classes. Investors should dynamically adjust their portfolios according to where the most attractive investment opportunities are at different times.
Another important distinction to be made when talking about the yield from a portfolio is the standpoint from where the return is measured.
When I talk about the yield on my fund, I am referring to the prospective return over the forthcoming 12 months as a percentage of the current share price, based on the estimated gross yield from the fund’s underlying investments.
By contrast, the historic yield quoted for the fund is the actual amount distributed over the previous 12 months as a percentage of the current share price.
Historic yield may not always be a good representation of what can be expected in the future since it will vary with changes in the share price of the fund. If the share price of the fund were to fall significantly over the 12 months, then the historic yield would appear higher than if the price had been stable or risen, even though the same amount had been distributed.
If I am successful in my objective of generating capital growth as well as income, then the historic yield on my fund will always be less than the 4 per cent I am aiming to provide. This is because the share price will be higher at the end of the 12-month period than at the start, thus reducing the yield despite having met the income objective.
In conclusion, the best way of satisfying the income requirements of pensioners is to generate a steady, achievable rate of return from a growing base. Today’s capital is tomorrow’s income.
Steven Andrew is manager of the M&G Episode Income fund. The views expressed above are his own and should not be taken as investment advice.
