Words on Wealth: What to consider when investing for income

Investing for an income is what you do, for example, when buying a life annuity with your retirement savings. You aren’t investing for some long-term accumulation goal; you are putting your money in an investment that will hopefully give you a sustainable return from which you can withdraw at regular intervals for your day-to-day living expenses.

Your income from this investment needs to increase each year in line with inflation, and your capital needs to last as long as possible before your withdrawals start depleting it to any great extent.

Returns on investments in any asset class except cash have two components: capital growth and yield, or income

Equities: capital growth comes from a rise in the share price; yield comes in the form of dividends.
Bonds: capital growth comes from a rise in the bond price; yield comes in the form of interest.
Property: capital growth comes from a rise in the property price; yield comes in the form of rental income.

One would think that yield would be the primary consideration of investors investing for an income. But it turns out that, if you are prepared to withstand the higher volatility of equity investments, capital growth can play a big part in your returns.

Recently, in a column titled “Will your draw-down strategy let you down?”, I covered research by Joao Frasco, the chief investment officer at Stanlib Multi-Manager and INN8 Invest on the types of investment that offer the best chance of providing a sustainable income for retirees. It turned out that the best investment historically, over 30 years with an initial draw-down of 5%, was a high-equity multi-asset fund. These funds, commonly known as “balanced funds”, typically invest about 65% in equities, about 25-30% in bonds, with a smattering of listed property and the rest in cash.

Using a balanced fund as an income-generating investment in your retirement was also raised in an earlier column, “Your retirement portfolio needs equity exposure – and you need to cope with the volatility”, in which I put questions to Earl van Zyl, head of product development at Allan Gray. He said that, from research his team had done, “the principles don’t change that much between pre-retirement savings and post-retirement savings, certainly when your time horizon is long enough. A balanced fund turns out to be a very good solution for clients, whether they are pre-retirement or post-retirement.”

But hang on, you may ask, there unit trust funds that specialise in income. Surely these should be the first choice for retirees?

Income funds focus on optimising the yield component of return over the capital growth component. You find them in the two interest-bearing categories (funds investing in bonds and cash) and in the multi-asset income category. According to the classification standard by the Association for Savings and Investments South Africa (Asisa), multi-asset income portfolios “invest in a spectrum of equity, bond, money market, or real estate markets with the primary objective of maximising income. These portfolios can have a maximum effective equity exposure (including international equity) of up to 10% and a maximum effective property exposure (including international property) of up to 25% of the market value of the portfolio.”

Each quarter, Corion Capital releases a report on income-focused collective investments, the Corion Quarterly Income Report. According to the report, over a year to the end of September the three categories had the following returns:

Multi-asset income funds: the top-performing fund returned 13.1% and the worst 2.3%, with the average return in this category about 9%.
Interest-bearing short-term funds: the top performer returned 10.9%, the worst performer 6.7%, and the average was about 8.8%.
Interest-bearing variable-term funds (investing in longer-dated bonds): the best return was 11.5%, the worst 1.0%, and the average was about 6.5%.

Inflation was 4.8% in August, so average real returns in the three categories were 4.2%, 4.0% and 1.7% respectively.

Variance in returns and volatility in income-focused funds are lower than in funds with a higher equity exposure, so for volatility-averse investors, these funds may hold some appeal. But bonds are not without risk, as the world has seen over the past year or so, as higher interest rates have played havoc with the bond market.

Acknowledging the differences in volatility, let’s compare annualised returns over 10 years, which should smooth things out. This is from data supplied by ProfileData on unit trust performance to the end of March.

Multi-asset income: best 8.41%, worst 4.19%, average 6.80%
Interest-bearing short-term: best 7.49%, worst 5.30%, average 6.80%
Interest-bearing variable-term: best 7.83%, worst 4.12%, average 6.95%.

Then compare with: