The search for yield in a low-interest rate world has led many investors who must live off their capital – or at least rely on dividends to cover part of their costs – into some very odd places. Sadly for unlucky income-seekers, particularly those taking up pension freedoms, the price of a high yield today might be capital erosion tomorrow.
However, the good news is that more than a dozen conventional equity-based investment trusts still deliver inflation-beating yields of 4% or higher. Better still, your humble correspondent owns two of them – including the top-yielder, European Assets Trust (EAT) paying 5.3%, and Henderson Far East Income (HFEL) paying 5.5%.
Perhaps more importantly, looking forward, the unique structure of investment trusts suggests that many may continue to throw off cash – just as some have done for several decades in the past. None has done so for longer than City of London (CTY), the UK equity income trust that has increased its dividend for an eye-stretching 51 consecutive years.
While the past is not necessarily a guide to the future, the fact that the same manager – Job Curtis – has been at the helm of this £1.45 billion fund for more than 26 years does provide investors today with reasons to be cheerful. They certainly aren’t being charged too much for Curtis’s expertise. Ongoing fees of just 0.42% are the cheapest in the Association of Investment Companies (AIC) UK Equity Income sector and make many other funds with lower returns look very expensive.
Curtis confirmed this week that identifying sustainable dividend yields is ‘most important’ in delivering the trust’s objective of rising income with capital growth. Interestingly, 69% of City’s assets are allocated to FTSE 100 shares; 19% to medium-sized companies and 12% to overseas stocks.
By contrast, worrying analysis from AJ Bell that shows how heavily reliant on a few blue chip shares many home-bias British investors have become. Just 10 of the constituent companies in the FTSE 100 index will pay out 58% of its dividends forecast for this year.
With earnings cover looking increasingly stretched and abundant opportunities for political events to deliver unpleasant surprises – don’t mention the Brighton Bolsheviks or the Terrible Tories at Manchester! – investment trusts’ ability to smooth distributions looks more important than ever. Unlike unit trusts, investment trusts can withhold up to 15% of returns from underlying assets in good years to sustain dividend payouts in bad years.
The AIC’s helpful website shows how much each trust holds in cash reserves and how many years’ current payouts that sum would cover. So, for example, City has nearly £49 million cash reserves which equal 0.82 of annual payouts; European Assets distributes everything and has no reserves; while Henderson Far East Income holds £22 million in reserve, equal to 0.86 of annual distributions.
Iain Scouller of analysts Stifel points out: ‘Many equity income trusts have meaningful revenue reserves that can be useful as and when there are dividend cuts at the portfolio companies in which they invest. These investment trusts should be able to deliver a more robust level of dividend than similar unit trusts which do not maintain reserves.’
This makes it all the more outrageous that most financial intermediaries continue to recommend open-ended funds for pensioners embarking on income drawdown, where capital is irreplaceable and sustainable payouts are of paramount importance. So I make no apology for repeating that this will be the next pension scandal.
When will the sleepy City watchdog that is the Financial Conduct Authority wake up and show its teeth? Not before thousands of pensioners have lost their life savings and are unable to support themselves in retirement, to judge from the FCA’s complete indifference to numerous warnings here and elsewhere.
It is a cruel paradox that pension freedom will imprison many ill-advised income-seekers in an impoverished old age.
Full disclosure: here is a complete list of Ian Cowie’s stock market investments. It is not financial advice nor is any recommendation implied.