In the post-pension freedoms world the search for income is one of the biggest challenges for IFAs.
Do advisers look to equity income and income funds for their clients’ drawdown, using so-called natural income? Or would they prefer to use, say, a multi-asset fund and sell off units?
For IFAs who prefer the former option, 2017 was a rocky year with some high profile disappointments. Most notable was star manager Neil Woodford (pictured) and his UK-based Woodford Equity Income fund (see graph below).
Woodford’s fund took big hits from a handful of companies in 2017. The most notable resulted from the share price collapse of doorstep lender Provident Financial last summer – an issue that is still rumbling on today.
While Woodford’s disappointment was driven by the performance of a small number of shares, the wider issue of company dividends has been pushed further into the spotlight recently.
The collapse of building giant Carillion has raised the question of the sustainability of dividend payments among some companies with large defined benefit (DB) pension deficits.
In light of Carillion’s collapse, which will leave thousands of members in the Pension Protection Fund, Royal London director of policy Steve Webb tweeted: ‘2016 Carillion annual report says dividend “has increased in each of 16 years since formation of company”; Is this really acceptable alongside a pension fund deficit over half a billion pounds?’
With UK dividends likely to come under the microscope, particularly from politicians, is it wise for advisers to stick with equity income for drawdown in 2018?
For Charles Chami (pictured above), director of Bristol-based Glamis IFA, UK equity income funds form the basis of his firm’s portfolio for clients in drawdown. They provide a ‘buffer’ to any losses in case of a downturn.
‘In an up-market the yield will increase the overall returns, in a down-market it will cushion any reduction in value, so it has value at both ends of the spectrum,’ he said. ‘So if a sector is yielding 4% and the market is up 10%, you have 10% plus 4% – so it increases on an upside. If a market is down 10% but you are still yielding 4% then overall you are maybe down 6%, so that income provides a buffer to any capital reduction.’
Chami has some clients in Woodford’s Equity Income fund. He said he is confident performance will pick up in the coming months and he thinks it would be risky to disinvest now.
‘In the case of Woodford, he has performed well in down-markets in the past,’ he said. ‘If you look at where the UK equity sector is, you could argue there is more downside risk than upside potential. So why sell the guy that does well in underperforming markets if that is where you think we might be heading?’
It is not just advisers who are keeping faith in the UK equity income sector. Ex-Artemis UK income star Adrian Gosden (pictured above) is launching a new equity income fund for his new firm GAM. Meanwhile Legal & General Investment Management launched a new European equity income fund earlier this month.
Speaking at the New Model Adviser® conference earlier this month Gosden said he had ‘sympathy’ with advisers who believe the ‘UK equity income [market] is dead’ because there was such a split in performance among managers in 2017.
‘The top performing UK equity income fund did around 25%, and the bottom one, which did a negative number. The difference between the two was too big for advisers to look at the sector and say: “this is great”,’ he said.
‘There is so much variation in the sector. If you agree equity income is a good way to beat the All-Share, which it is 70% of the time, selecting the right manager is crucial.’
Gosden’s strategy for ensuring his equity income fund performs well is by moving ‘away from bond proxies and a total infatuation with overseas earnings’ during Brexit. Instead he is moving to companies ‘linked more to the economics [and] more linked to our own nation’.
‘These changes will be slight but, when you look back, they will be quite significant,’ he said.
What do clients want?
Scott Gallacher, director of Leicester-based Rowley Turton Private Wealth Management, said if he was retiring tomorrow, and he had enough money, he would want most of his pot in equity income funds. However, because clients get nervous if there is a downturn and do not have enough appetite for risk, this is not what he does for his customers.
‘[Equity income] is perfect for giving you an income in retirement that may last 30 or 40 years without running out of capital,’ he said. ‘But people don’t get that. If they hold it for a number of years and there is a big crash, they panic and sell. That is the worst-case scenario.’
When asked if cases such as Carillion will lead to more companies cutting dividends, Gallacher said companies with big DB schemes were most likely to stop the payments.
‘If you are not generating enough profit to justify your level of dividend and you have an increasing liability due to a DB scheme, cutting the dividend is easier to do,’ he said.
Gallacher said that while UK and US companies are seeing their dividends come under pressure, emerging markets are beginning to move towards dividends. Therefore, he said, it would be balanced out in a global equity fund.
|Name||Rating||Rank||Total return||Contributing Fund(s)|
|Henry Dixon||AA||1/102||26.74||Man GLG UK Income Retail|
|Charles Montanaro||+||2/102||24.6||Montanaro UK Income Sterling Seed|
|David Taylor||AAA||3/102||24.25||MI Chelverton UK Equity Income|
|Jonathan Barber||100/102||3.5||Threadneedle UK Monthly Income Retirement Net Income|
|Simon Holman||101/102||2.74||Castlefield B.E.S.T Income - Retail|
|Neil Woodford||102/102||1.15||St James's Place UK High Income|
|LF Woodford Equity Income|
|Old Mutual WoodFord Equity Income|
|Woodford Equity Income Feeder|
However, not all advisers favour the income fund route. Christopher Morgan, director of Cardiff-based Planet 3 Wealth, prefers the total return option and selling off units for client income.
‘It gives us some element of uniformity and a repeatable and robust outcome for clients whether in accumulation or decumulation,’ he said. ‘For clients in decumulation the tail-end of their portfolio, which is a total return fund, is doing the same as the client in the accumulation phase. But those in the accumulation phase just don’t have that leading edge of cash.’
Abraham Okusanya (pictured above), director of consultancy FinalytiQ, said he adheres to Warren Buffett’s investment philosophy that there is no reason to prefer dividends over capital growth. Buffett believes if a company performs well it can use that capital for business investment rather than paying out shareholders in the short term.
Okusanya said the idea ‘pound cost ravaging’ (pension pots suffering from losses early on in the investment term) can be avoided by using income funds is a ‘myth’.
He added people should reflect on Woodford’s recent run, as well as the recent Carillion collapse, to understand this.
‘People sometimes hang on to the idea for a long time that equity income funds deliver some kind of superior performance than others,’ he said. ‘But occasionally issues like Woodford, Carillion and like BP a few years ago turn those ideas on their head.
‘I hope people pay attention to the lessons we are learning from these instances.’