When it comes to generating income from investments, how you put your money to work is just as important as how much you have put aside. Investing across a breadth of different assets can help deliver a more reliable income stream. Seeking income from too few sources could ultimately put your aspirations in jeopardy.
Home bias is a common problem in this respect. For British savers, the fact that UK assets can be both more familiar and easier to invest in, means an outsized portion of our investments are domestic.
This poses risks which, importantly, are not all about Brexit. They are a result of the current structure and valuations of the UK bond and equity markets.
Historically, bonds issued by the UK government (known as gilts) have played an important part in generating income for British retirees. The attractions of a government-backed income stream are probably obvious.
However, over the past five years the prospective returns on assets traditionally seen as among the lowest risk investments, like gilts, have fallen to record lows. Demand has pushed up their price, and this has depressed yields -- which represent the annual investment returns as a percentage of the price paid.
The yield on benchmark 10-year gilts fell below 1% in 2016 and remains well below the rate of UK inflation. Significantly, gilt yields have diverged from those on 10-year US government bonds, which climbed above 3% in 2018.
Gilts’ lower yields reflect, in effect, a relative premium in the price being paid for that meagre income stream. Should demand for gilts fall – perhaps if UK interest rates rise – and this premium be eroded, the value of gilts will go down.
… and precarious dividends
At face value, the UK stockmarket might look like a much better place to invest for income.
Many blue-chip companies are returning large profits to their shareholders through dividends that can appear attractive. Dividend yields – the value of annual dividend payments as a percentage of the share price – exceed 5% or more in several cases.
Over the past five years or so there has been a growing divergence between the prospective income that can be generated from investments in UK company shares versus that from UK government bonds.
However, behind these headline figures lies an uncomfortable reality: UK company dividends are highly concentrated. Practically half (49%) of the total value of dividends paid out by FTSE 350 companies over the 12 months to 31 July 2018 came from just 10 stocks, for instance. Three companies – Royal Dutch Shell, HSBC and BP – alone accounted for 22% of total dividend distributions. This can pose a risk, since any company’s management can reduce dividend payments, or cut them altogether, at any point.
Then there is currency risk to consider. Given that many FTSE 350 companies operate globally, income is largely earned – and dividends are in some cases declared – in other currencies. This means that the sterling value of dividends, which matters to UK investors, can fluctuate according to the relative value of the pound at the time.
The stronger the pound, the less overseas income will be worth once converted. Of course, the opposite is true – the weaker the pound, the more overseas income will be worth. While this isn’t anything new, it is perhaps more significant for dividend investors at a time when the pound’s value has proven more volatile.
Widening the net for income
It has been argued for some time that investors everywhere can benefit from diversifying beyond domestic markets.
Today, I believe UK investors who are targeting a reliable and hopefully growing income need to pay attention to the risks of home bias. An overdependence on domestic sources of investment income could prove most detrimental to those in retirement.
Savers should be prepared to seek out attractive investments across a breadth of countries, sectors and types of assets. I believe this flexibility will better enable them to capture investment opportunities and provide for a more comfortable retirement in a highly changeable world.
The views expressed in this document should not be taken as a recommendation, advice or forecast.
When you're deciding how to invest, it's important to remember that the value of investments goes up and down. So how much your investments are worth will fluctuate over time, and you may not get back the original amount you invested. If you’re at all unsure about the suitability of any investment, please speak to a financial adviser.