How a natural income fund could protect your long-term financial security
01/04/2022With rising inflation and increasing interest rates, Russia’s invasion of Ukraine, and the ongoing Covid pandemic, there are plenty of reasons why the stock market has had an uncertain first quarter.
With this in mind, you might be wondering how to take an income from your investments without eroding the capital invested. As a client of Douglas White, you have the peace of mind that your income strategy will be carefully considered to help ensure it’s as sustainable as possible.
That said, you may know others who could be putting their investments at risk by taking a level of income that means they are eating into the capital. If you do, there might be a way for them to draw a flexible income that won’t erode their investments, no matter how the stock market performs.
Read on to learn more about “natural income” and how it might be used.
Natural income is typically generated by dividends and interest payments
Natural income typically consists of dividends generated from the stocks and shares element of your investment, as well as interest on cash or bonds. Interest paid on bonds is usually referred to as “coupons” and is paid every six months. If your investment includes property, this could also include rent received.
When you take natural income, you only take the amount the dividends, interest payments, coupons, and rent have generated, which can vary depending on investment performance. That said, the dividends paid by companies may not be dictated by their share price, which means they might be paid even if the market takes a downturn.
This differs from taking a set amount of income, which typically means you have to sell more units within your investment to boost your income to the level you require. As this means selling more of your investment, it may not last as long and could put your long-term financial security in jeopardy.
Let’s look at why this is.
Taking a set income might jeopardise your financial security
If you take £1,000 from your investment when shares are worth £1 each, you will cash in 1,000 units. If the value of each unit drops to 80 pence, then you will need to cash in 1,250 units to generate your £1,000 income. This means you have fewer units left to benefit from potential future growth.
While your income remains the same, the impact it is having on your capital could be much more severe than you realise. One way to show the effects of drawing an income from an investment when the market has taken a downturn is to look at “sequence risk”.
While sequence risk typically refers to a downturn in the market as you start to draw an income from your pension, it can also apply to general investments. In simple terms sequence risk says that bolstering your income during a downturn means selling more of your investment, which reduces longevity.
To demonstrate this, consider the following illustration that shows its potential impact on a pension. The graph assumes the same average growth rate each year for three different scenarios, which are:
- Your pension performs as expected (consistent investment scenario)
- Your pension pot enjoys a boost in value because of a market upturn (strong start)
- Your pension suffers a fall in value because of a market downturn (poor start).
Source: LV=
As you can see, with the poor start scenario, the pension is depleted more than five years before the average life expectancy. The same could happen to a general investment if someone was taking a set amount of income.
Using natural income as part of your financial strategy could help
While natural income could help ensure you do not deplete your investments, care still needs to be taken. This is because the level of income you receive varies according to the amount of dividends interest and coupons paid.
As none of these are guaranteed, the level of income could fluctuate.
As a result, there could be a risk that the natural income generated does not reach an adequate level of income for you to meet your financial obligations. For this reason, taking a natural income may not always be appropriate, and professional advice should always be sought.
So, taking a natural income might be worth considering as part of a financial strategy if you’re currently drawing set amounts of income from multiple investments.
Alternatively, it might be better to consider drawing a set income from one investment that allows you to meet your financial obligations and take a natural income from the others.
This could allow you to afford those “nice to haves” when the natural income pays enough, allowing you to enjoy them with the peace of mind that you’re not putting your long-term financial security at risk.
Get in touch
While natural income investments can make sense, you need to ensure they are right for you. If you know someone who may benefit from using natural income, or you are interested in finding out more for yourself, we would be happy to discuss our income growth fund, and how it might help.
Just email us at info@douglaswhiteltd.com or call 0151 345 6828 and we’d be happy to talk.
Please note
This article is for information only. Please do not act based on anything you might read in this article. All contents are based on our understanding of HMRC legislation, which is subject to change.
A pension is a long-term investment. The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Your pension income could also be affected by the interest rates at the time you take your benefits. The tax implications of pension withdrawals will be based on your individual circumstances, tax legislation and regulation, which are subject to change in the future.
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