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Why is income growth so important?

Posted by: Brian Dennehy
Membership level: Free

 

To take advantage of the potential of the best equity income funds, investors must adjust their mental approach i.e. away from an obsession with day to day moves of the capital value, to a greater focus on the lack of volatility and relative predictability of the income.

Assume a 60 year old investor invests in two funds, each paying out £10,000 of income in the first year.

Fund Z will increase payouts by 5% p.a., and Fund X by 10% p.a. 

What is the situation by the time the investor is 75, fifteen years later?

  • Fund Z. The initial income is £10,000 p.a., with 5% growth in the payout, the income grows to £20,789. 

  • Fund X. By age 75 the initial income of £10,000 p.a. is £41,772 i.e. twice as much.

Payout growth over 15 years at 5% and 10%

Age Payout at 5% growth Payout at 10% growth
60        10,000        10,000
61        10,500        11,000
62        11,025        12,100
63        11,576        13,310
64        12,155        14,641
65        12,763        16,105
66        13,401        17,716
67        14,071        19,487
68        14,775        21,436
69        15,513        23,579
70        16,289        25,937
71        17,103        28,531
72        17,959        31,384
73        18,856        34,523
74        19,799        37,975
75        20,789        41,772

The staggering differential desperately needs to be grasped by UK investors.

The problem for UK investors is that they are invested in a large number of UK equity income funds which resemble fund Z.

It’s also not just about the yield

A decent starting yield is important.  But the yield doesn’t tell you about the quality of an income fund. This often gets confused media coverage. Here’s an example:

A fund is 100p yesterday, and pays out 5p as a dividend.

Therefore, the yield is 5%.

An income investor buys that fund yesterday based on the yield of 5%.

If the dividend payout falls to 3p tomorrow - this is not good for that existing holder, who relies on income.

The yield then becomes 3%. But the existing holder of the fund is no longer interested in the yield, only the payout in actual money – the 5p or 3p.

Conversely, say that when the payout is cut to 3p tomorrow it coincides with the fund price falling from 100p to 50p.

The yield is then 6%.

But again, our existing fund holder doesn’t care that the yield has gone up – he only cares that the payout has gone down.

ACTION FOR INVESTORS

  • Investors need to change their mental approach when looking for income.
  • Think of the income portfolio like your heart pumping out blood - the heart continually changes shape as it pumps out a steady stream of blood.  
  • The capital value of your income portfolio will also vary from day to day, but there will be a steady flow of income, growing income.

FURTHER READING

Topic: Generating income


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