How to structure your income portfolio
The prospect of companies cutting their dividends is looming large again. On 14 May Vodafone (VOD) cut its dividend, ending a two-decade long steak of increases, while there are further warnings that other sectors such as insurers are feeling the crunch and could take the axe to their payouts.
This will be a worry for many retirees, who rely on the steady drip-feed of dividends from these companies to provide the income they draw from their pension. Whether you invest in the stocks directly or have exposure via funds, it’s likely that your retirement pot will be affected if some of these giants start cutting.
That doesn’t mean you need to panic, but it can be a good time to revisit where you get your income from and how to splice up your portfolio to give you the best chance of having a steady, but also growing, income.
Many professional fund managers who run income funds will cut their portfolio up to target different needs. They are expected by investors to provide a decent income today, but also to ensure that the income keeps pace with rising prices, namely inflation.
An investor in a fund getting a 4% yield today, so a £40 payout on every £1,000 they have invested, is not going to be happy getting that same £40 payout in 10 years’ time, as the spending power of that money will have diminished.
In real-world terms, if you retire today and work out that you can withdraw a £20,000 annual income from your pension pot, you want that amount to grow with time, in the same way as a salary would increase each year.
In 10 or 20 years’ time that £20,000 will buy you far less. As an example, a £20,000 income in 2008 would need to be £26,215 today just to have kept pace with inflation.
You need to balance this growth for the future with income today. Here’s how.
You need some income payers in your portfolio that are reliable dividend payers. It’s impossible to know whether a company or fund will continue its current payout, but you can look at the track record and the financials to give you a good idea.
This group of stocks or funds should be the backbone of your portfolio, they should pay out a decent income and have a solid track record of doing so in the past.
If you pick stocks they are likely to fall into some of the less volatile sectors, such as consumer staples, but they will be on the more boring side, plodding along churning out a decent dividend and not giving you too many sleepless nights.
In an ideal world the income-producing characteristics of these investments will mean they are attractive to other investors too, and so their share price could also rise in time, delivering you some capital growth too.
These stocks or funds might not be yielding enough today for you to think of them being worthy of inclusion in an income portfolio, but these are your winners of tomorrow.
Thanks to the aforementioned solid backbone of investments (and the next group below), you can afford a slightly lower income today from this group of companies or funds. However, what you’re looking for here is the ability to increase the dividend ahead of inflation in future years.
These are the assets that will help you to get a growing income in the future. They are likely to be younger, smaller companies (but not always) who are growing faster than your Steady Eddies and are focused on a good dividend policy, or funds that invest in these stocks. As they grow and increase their revenues, they’ll also be able to grow their payouts faster.
To balance out these lower payers today you will want to allocate to some companies or funds that are delivering a high yield right now.
If stocks, they will be handing out decent dividends in comparison to their share price and will help bolster your portfolios’ payouts in the short term.
Typically stocks with larger yields are higher risk, as the market has pushed down their share price due to uncertainty around the future earnings or growth prospects.
If you go down the fund route, the group you’re likely to be looking at are so-called ‘income maximiser’ funds for this section of your portfolio.
These funds use derivatives, and so are a bit more complicated than your average fund, and they effective sell some of the future capital growth of the fund in exchange for higher income today. Like the stocks above, they are riskier.
How much you allocate to each group depends on myriad factors. Most importantly you need to look at the risk you’re willing to take with your income portfolio, but also the level of income you want today and how reliant you are on that.
You also need to think about whether you’re willing to sacrifice capital growth today for a higher income, or if you’re more reliant on growing the income in the future. Whatever split you decide on, make sure you monitor all of the constituent parts to make sure they’re living up to your expectations.