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People retiring today can expect to live longer than the generation that preceded them. For a long retirement of 30 years or more, a suitable investment plan is vital.
Many rest on the idea that their pension might see them through, others save their money in high street savings accounts. For short-term needs and fast access to funds, cash savings are hard to beat.
However, over the longer term, merely saving money as an investment principle can be disastrous for anyone needing their capital for retirement.
To put such a move in to perspective, at the time of writing the current rate of inflation stands at around 1.7%. This amount would reduce the real value of £10,000 to £8,424 over 10 years. Over 20 years and your initial pot is worth only £7,097. Over 30 years, the real term value of £10,000 is a measly £5,979.
Simply saving your money is not going to see you through your retirement. However, there is an investment strategy that stands above every other choice as far as providing a sustainable income for your retirement years – it is called equity income.
What is Equity Income?
Equity income is a dividend income that is earned through the investment in stocks (equity).
An equity income fund is a type of mutual fund that invests in high-quality companies with a reliable history of dividend payments and growth in the dividend rate.
The beauty of equity income is that it provides the potential for not only a growing income but for capital growth at the same time. This gives investors a hedge against the effects of inflation on their savings and investment capital.
Equity Income vs Traditional Savings
Traditionally, there have been two main issues that people rise when comparing equity income with deposit savings accounts. The fact was, the initial yield from a building society was often superior to that from equity income.
However, that is no longer the case. With the aforementioned interest rates being as low as they are, (with no real signs of improvement from a savers point of view), yield from a savings account is of little benefit, especially after the effects of inflation.
Another point is that investors are understandably uncomfortable with the way initial capital value can fluctuate, when invested in equity income. Equity income does not have the guarantee of capital provided with a bank or building society deposit.
However, the possible returns help counter those initial concerns. As we have already explained, relying on just a savings income is highly unlikely to see you through any lengthy retirement. If you want higher returns on your capital, a little risk is required.
Share price, income and yield
Before we look into the process of buying equity income, and what yields can be expected, we should clear up some of the more common terms used when investing in this way.
Share prices, income and yield are not the same, yet they are intrinsically entwined.
Income is the actual amount of money you receive from a share’s dividend. Yield is this income expressed as a percentage of the current share price. If a company pays a consistent dividend, but its share price changes, so will the yield.
Let’s cite an example. Imagine you purchased one share for £1.
The company pays a consistent dividend of 4p per share – this would be represented as a 4% yield when the shares trade at £1.
However, as the share price goes up in price the yield falls, as the dividend is now a smaller proportion of the value of each share.
If the share price doubles to £2, the yield falls to 2%. This in turn means the income amount does not change; you would still receive your 4 pence per share.
How To Buy Equity Income
One of the best ways of investing in equity income is through unit trusts or OEICs.
When you buy any units there is an initial charge however this can be discounted (often to zero) if you invest through a fund supermarket.
The fund managers make an annual charge, often deducted from capital. This essentially means that you will receive the quoted yield in full.
You are paid this on an annual basis, net of basic rate tax, and if you invest in an ISA or SIPP there is no further tax payable on this income, whatever your tax rate.
Unlike cash, stock market investments are not guaranteed so their value and income can fall as well as rise, so you could get back less than you invested. Also, inflation will erode the spending power of capital and income over time.
The total yield from equity income
Potential investors in equity income should only use capital they are unlikely to touch.
This is due to the certain factor that capital invested in the stock market will fluctuate in value.
As is the nature of this type of investment, some investors may see short-term capital decline in line with stock market fluctuation. This is something that would-be investors need to be prepared for.
Also, not all investments will see improvement over the long term either. It is an economic certainty that some companies will go into decline for any number of reasons and lose investors money. Of course, it is the job of the fund manager to avoid these.
Overall however, there remain very few investment choices that can potentially improve income year by year and that in the medium-to-long term will also become more valuable, than equity income investing.
