Getting an income from savings
This column in the series on investing discretionary money – such as retirement fund lump-sum payments, particularly from provident funds – to generate an income focuses on product choice.
Investing for an income is significantly different from investing to build a lump sum of money (capital growth). As a consequence, financial products are modelled to take account of the differences.
As with all investments, you need to take care, because the risk profiles of products that purport to provide an income can vary dramatically.
One of the main objectives of investment for an income is to preserve capital so that there will be sufficient capital to maintain a meaningful and sustainable income for the period required.
No investment product can guarantee that it will provide an income return that will make up for a shortfall in savings (capital). If it does, it is likely to be very high risk.
The two major risks faced by people seeking income-generating investment products are:
* Loss of capital because of a high-risk investment. The risk can vary from investing in a scam Ponzi scheme or the currently fast-imploding property syndication market, to investing in a narrow section of the equity market that turns out to be in a price bubble, and then facing a market collapse.
* Inflation. If you invest in a conservative but virtually capital-secure product, such as a bank term deposit, both your capital and your income flow are likely to decrease in their buying value in line with inflation. For example, if interest rates are four percent and inflation is six percent, then your money is devaluing by two percent a year.
With most income products you need to take some risk in that to preserve your capital you also need to protect it against inflation. This means you need some capital growth, which comes with additional risk.
This column deals with mainstream products that offer income streams generated by capital growth and dividend, interest and rental income.
It does not deal with high-risk products such as property syndications, or currency speculation and debt traders, such as the company Cambist. These types of products, which often target pensioners who are desperate for higher returns, should be avoided. You should question the integrity of anyone who wants to place you in them, particularly if the commissions are above three percent of your investment.
Income products you should consider include voluntary purchase annuities, RSA Retail Bonds, income unit trusts, and income plans (see below).
Then there is the old-fashioned way of simply putting together a quality portfolio of shares of companies that pay steady and increasing dividends.
The point is that there is a wide range of regulated products out there, from those that offer meaningful guarantees on both income and capital, through to those without guarantees, such as unit trust funds, which will give you varying degrees of peace of mind without unacceptable levels of risk.
VOLUNTARY PURCHASE ANNUITIES
Voluntary purchase annuities (VPAs) are guaranteed income products offered by the life assurance industry. VPAs are similar to compulsory purchase annuities (CPAs), which must be purchased with at least two-thirds of the accumulated savings from a pension or retirement annuity fund and the pension must last at least for the life of the fund member.
The three main differences between CPAs and VPAs are:
* Tax. With a CPA, the full pension, be it from fund returns or from capital, is subject to income tax at your marginal rate of taxation. The reason is that you have received tax exemptions on your contributions and investment growth.
A VPA, on the other hand, is bought with money that has already been taxed. This means that only the investment return portion (and not the capital portion) of your income is taxed in your hands, at your marginal rate of tax, when you receive it.
The build-up of investment returns of a VPA, as with a CPA, are not subject to income tax, dividends tax or capital gains tax. So you are deferring tax (and receiving returns on the amount) until it is paid as part of your taxable income stream.
* Term. A CPA is for life, while a VPA can be for a fixed term or for life. The annuity (pension) options for both a CPA and a VPA are about the same.
* Guarantees. The guarantee on a CPA is that you will get a pension for life. You use your capital to purchase the pension and the pension must then be paid at least until you die.
With a VPA you can get various guarantees, namely:
– On your income only. This may entail getting a pension for a fixed period or until you die without receiving any capital at the end of the term.
– On your income, but with the amount of capital you receive at the end of the fixed term dependent on the investment returns, which may result in you receiving more or less than your initial capital at the end of the period.
– On your income and all or part of your capital.
The more capital you want guaranteed, the lower your pension will be.
The annuity options for CPAs and VPAs are much the same. They include:
* Level annuities. These annuities will pay the same rand amount for the term of the annuity.
* Escalating annuities. Designed to take account of inflation, the annuity will escalate in line with inflation or at a predetermined rate, such as five percent.
* Enhanced annuities. These annuities, which are not widely available, will pay higher pensions if you are not in good health and can be expected to die at a younger age than normal.
* Joint and survivorship annuities. These pensions continue to be paid until the last dying of a couple.
* With-profit annuities. Your initial pension is guaranteed, but future increases will depend on the profits made by the underlying investment portfolio. Once an increase is granted, it is guaranteed for the rest of the term.
RSA RETAIL BONDS
RSA Retail Bonds are government-sponsored products that can be used for savings and income generation.
* Your investment is tied up for a period that, depending on the bond, ranges from two to 10 years.
* You can draw your returns (interest) on a monthly basis.
* You can select a fixed rate of return based on bond yields (debt issued to institutions such as the government for the medium to long term) or a bond linked to a specified rate above the inflation rate.
INCOME UNIT TRUST FUNDS
There is a whole sector of unit trust funds (collective investment schemes) dedicated to income funds. But do not be deceived: these are not your only choice.
The unit trust funds that are classified as income funds are restricted to investing in interest-earning investments, such as bonds and cash. You will find funds in a number of other unit trust sectors – of which the fixed interest varied specialist sector is the biggest – that also specialise in generating an income. These funds are permitted to invest in interest-earning investments as well as listed property shares.
However, portfolio managers know that a good source of income comes from dividends paid by listed companies, so you will also find income funds scattered among the various balanced fund (asset allocation) categories, where the manager is allowed to invest in all the asset classes, enabling funds to generate a cash flow from both interest payments and dividends.
A case in point is Marriott, an Old Mutual investment boutique specialising in income-generating products. Marriott has funds in numerous sub-categories, from the income funds through to the worldwide asset allocation flexible sector, in which funds are allowed to invest in the various asset classes both locally and abroad.
Obviously, the higher the equity exposure, the higher the volatility risk (namely, the propensity of the value of your capital to increase or decrease). But what these fund managers are seeking is the income flow. If that remains steady, then the underlying capital value is less important.
These are income products offered by linked investment services provider (Lisp) administrative platforms. In effect, these platforms allow you to put together your own combination of mainly unit trust funds to generate an income. You are also able to switch between the various options offered on the platform.
Some of the platforms are quite narrow, restricting you to only unit trust funds, while at least one, Momentum, allows you to include listed shares in your portfolio (giving you access to companies that pay high dividends) and exchange traded products, such as the Satrix Divi, which replicates an index of companies that pay out high dividends.
Costs are likely to be higher than selecting a single or a limited number of unit trust funds.