Annuity alternatives – 7% yields for your income drawdown plan

The Bank of England is hinting that interest rates will be going up sooner rather than later.  This will quite possibly push up annuity rates, so here we look under the bonnet of annuity alternatives, in particular income generated by funds within a drawdown arrangement.

At the moment, if a 60 year old buys an annuity now, with no widows benefit and no increases, the annuity rate is approximately 4.4%.  I will assume this might rise to 5% in the wake of broader interest rate increases.

With this in mind a fund alternative needs an income yield of 5% or higher.  Most UK equity income funds (those invested into UK companies paying higher than average dividends) have yields in the range of 3.2-4.2%.  The alternative is the small number of what we call income maximiser funds, and three of the best are listed in table 1.

The maximiser funds are more appropriate for income investors that need a relatively high income now, sacrificing the potential for that income to grow in future.  Plus you have to accept that they are sacrificing some capital growth to boost their income payout, and this is illustrated in table 2.  (see more explanation here Maximise Your Income Now)  Even so you must remember that there is no growth at all if you bought a level annuity as an alternative.  

We don’t like to get too much into “managing the managers” but the funds are fairly different in terms of the sectors that they invest in (see table 3 at end). For instance, Schroder Income Maximiser has a big weighting to banks (32%) while the Asian Income Maximiser has a similarly large weighting in Telcom, Media, Telcos.  Fidelity Enhanced has its highest weighting (26%) in Consumer Products.  The Asian fund also gives exposure to exciting opportunities in Asia and the Pacific as a contrast to the UK-focussed funds.

Schroders are very experienced Value managers - they seek out companies that are not correctly valued by investors (not just cheap but under-valued without good reason). They don’t try to be too clever by timing currency strength or weakness, and this is an approach that has served investors well.  

Over long periods a Value style is typically very successful, but it had some tough times since 2007.  This relatively poor performance changed dramatically during 2016 but has since seen a pause.  But we’d expect this trend to benefit investors over the long-term.

In Asia, high spending middle class consumers are key to economic growth, and in less than 20 years from now Asia will have 10 times more middle class citizens than the US, and five times more than Europe. That is an extraordinary global rebalancing that will drive company profits and dividends for decades to come.

Despite this there is still only around £3.9bn invested into these Asian income funds compared to £62.3bn in UK equity income funds (Q2 2017). This is blinkered, particularly when the Asian stock markets are about 27% cheaper than developed markets which include the UK.

There are also more choices in Asia.  For example, in the UK just 10 stocks will account for around 60% of total dividends compared to over 40 stocks in Asia-Pacific ex-Japan (according to Schroders).  In addition, Asia Pacific ex-Japan accounts for just 11% of companies in the global index but 39% of companies yielding more than 4%.

Last but least, this is not a once and for all decision.  You must review your funds every 6 months, and never more than every 12 months.  It doesn’t take long and the long term rewards from this approach should be substantial.

P.S.  If you want a growing income (smaller at the start, but great income growth potential) then do use the Income Tool.  Plus if you haven’t yet made the decision on income drawdown, we strongly recommend you seek out professional and independent advice, as this is too important a decision to get wrong. That being the case you are very welcome to contact the specialists at our parent Dennehy Weller & Co.

ACTION FOR INVESTORS

If you have made the decision to opt for income drawdown, and want to maximise your income, there are some great options.

FURTHER READING

• What is income drawdown? (external link)
• How to judge a good income fund
• Vanguard fans risk huge losses

Table 1: Yields

Table 2: Performance

Table 3: Sector breakdown