The use of capital to produce an income is one of the oldest and most widely held motivations for investment. While the objective remains the same, over time the profile of income investors has changed, and is now dominated by people either in retirement or approaching it, and who are seeking a replacement salary.
This shift in the investor base necessitates a change in the investment approach, but before looking at what changes need to be made, it is first worth considering how the needs of today’s income investors differ from those of the past.
The most important difference between the retirement-focused portfolios of today and the more general income portfolios of the past is that pension portfolios are more susceptible to non-investment factors such as demographic change, legislation and taxation. The impact of these factors has become especially clear over the last two decades as company pension provision has declined, and individuals have increasingly become required to take responsibility for their retirement savings.
However, the shift away from large corporate funds to personal plans has led to investment risks such as longevity and capital loss being focused on the individual rather than being distributed across a large group supported by a corporate sponsor. Personalised pension plans are less able than a large corporate scheme to adopt a long-term return-orientated approach, and instead must encompass the individual’s need for both income and security. This in turn has led to an ever greater focus on income-producing assets at the lower end of the risk scale, typically bonds and property.
The shift towards these assets may be demonstrated by data provided by the Investment Management Association. These show that the total size of the fixed income sectors in 2004 was £42bn compared with £126bn at the end of 2013, amounting to a growth of 199 per cent. In contrast, the assets held in growth-orientated equity funds have grown by only 128 per cent per cent over the same period.
This trend towards income-focused assets is likely to continue and even accelerate over the near future with the advent of greater access to pension funds at retirement. This huge change in the pensions market has already led to a precipitous fall in the use of annuities and is expected to presage a raft of new products and services as providers seek to accommodate the needs of clients with newly emancipated pension funds. While there will no doubt be a great variety of products launched, it is likely that income generation will be a unifying theme.
As ever greater amounts of capital are directed towards income-producing assets, the cost of that capital (that is, the return provided to investors) declines. This decline in returns can create a nasty feedback loop in which ever higher amounts of capital have to be used to generate smaller levels of income. The impact of this feedback loop is especially acute in the current cycle as central banks maintain interest rates at historically low levels. The impact of large amounts of capital chasing a limited number of income producing assets may be seen in the historic yield data of the income-focused IMA sectors (see chart 1). This shows that over the last five years, the yield from gilts and UK equity income funds have both fallen by 37 per cent.
