Exploring a wider suite of income investments
While the ‘income’ label is often applied to some defensive assets to differentiate them from growth assets, there are many growth assets that can provide a reliable income stream to investors.
There are five broad ways that income can be generated from an investment:
Table 1: Source of Income
|Typical asset classes
|Known, or pre-determined payments for the use of capital over a certain period. This is a contractual payment that must be made regardless of underlying profitability.
|Payment for the use of an asset, which is owned by the investor. This payment is usually contractual (i.e. not dependent of profitability) and the investor needs to maintain the asset over time to keep renting it out.
|Payment from profits to an investor that has provided capital to an enterprise. These payments will vary with the underlying profitability of the enterprise. In some cases this could entail the whole profit of the enterprise.
|Some investments use derivatives to generate income by partially transforming the capital in different market scenarios.
Equity option funds
|Regular cashflows for income can be generated through the consumption of capital in addition to the earnings on the investment.
Innovative annuity products
The challenge in this environment for investors who are seeking income is to generate income that is relatively stable and sufficient.
That will require investors and advisers to explore a full range of income options, including:
Cash and mortgage funds
These funds often represent secure investments that make income payments that reflect the level of the Australian cash rates.
Australian fixed interest
Investors in fixed interest aim to generate higher income than a cash investment, capturing a term premium for the duration risk and/or a credit risk premium.
Term annuities are fixed interest investments that provide regular income for a fixed term chosen by the investor, regardless of how share markets perform. The most common structure (known as an RCV100 annuity) provides regular payments based on a fixed rate over the period and returns the full capital amount at maturity. The capital is locked away for the period and, unlike a bond fund, there is usually no updated pricing for swings in the market.
Global and diversified fixed interest
This enables an Australian investor to tap into a broader range of assets that can provide regular income, though there is an additional risk to manage from different currencies.
A diversified fixed interest investment provides scope for the investment manager to add value by adjusting the exposure of the portfolio to improve the overall return and income.
Other income funds
A range of managed funds and ETFs in Australia are not based on traditional income asset classes but are still managed and marketed as income funds. Some of these are multi-sector funds that include traditional income assets and income strategies from growth assets.
While the underlying investments can be more volatile than traditional income assets, the income stream provided by the ‘growth’ assets is often not as volatile as expected. Dividend payments are more stable as companies seek to avoid cutting dividends unless absolutely necessary – resulting in dividend growth that is more stable but still aligned to the long-term growth in earnings and share prices.
Property and infrastructure income
Income from property investments is provided by the rental return less the cost of managing the property. In a managed fund, the capability of the property manager can impact the level of income that is available to the investor. Leverage is often used for property investments so investors don’t need to provide the full capital amount of the investment. This can be quite an effective strategy in accumulating wealth, with the ability of negative gearing to help an investor reduce their tax liability. It is generally a long-term strategy due to the lower liquidity in property and infrastructure assets.
Equity income strategies
An equity income fund with a dividend focused approach might invest in shares with high dividend yields and aim to capture more of the average returns from dividends than from capital gains. Investors need to consider if they are comfortable that the long-term growth and volatility of this type of investment will likely be close to the market return while generating higher dividend payments for income.
Another option for an equity portfolio is to use derivatives to generate income instead of the potential capital gains from the portfolio. This option can avoid the style drift of a dividend-focused approach, but execution depends on the available depth of options and derivatives available on the stocks. This approach may also work well for retirees for account-based pensions with a 0% tax rate. Derivatives can add additional risks to a portfolio so additional care is required with a derivative-based strategy to ensure that the investor is not leveraged to market exposures.
Annuities with RCV0 (zero residual capital value)
Another way to convert capital to income is to use a product that has no residual capital value on maturity such as some term annuities. A lifetime annuity can also have this feature, although it usually doesn’t have a maturity date. The RCV0 Annuity returns the capital to the investor over time to provide a smooth payment profile (that can be indexed to inflation). This provides a direct method of converting capital to income. The annuities market in Australia is growing in sophistication with new annuity-style products being introduced with dynamic features.