The best way to net yourself an income

Published by Faith Glasgow on 19 May 2011.
Last updated on 09 June 2011

There's currently little joy to be found for those looking to generate an income from their savings. Consumer prices inflation has just hit 4%, meaning basic-rate taxpayers have to find an account paying 5% interest just to stand still.

It's not surprising, then, that many income-hunters have turned to dividend-paying shares over the past few years.

However, dividend payments aren't what they used to be, so if you want an income from your investment trust you'll need to know what you're doing.

Dividend payments on the up

Yields (a share's dividend as a percentage of the current share price) have been attractive in comparison with cash. But for long-term equity investors there's also the likelihood of capital growth as their shares steadily gain value over the years.

However, 2010 turned out to be a difficult year for income seekers. While UK businesses did quite well overall, increasing their payouts by an average 7.5% in 2010, the loss of the massive BP dividend, suspended in the wake of the Gulf of Mexico oil spill, meant the total value of distributions fell by 3.3%.

But there's better news on the horizon for 2011, according to the latest Dividend Monitor report from Capita Registrars.

For a start, BP has reinstated its payouts and is predicted to reward investors with dividends totalling around £2.8 billion.

Capita's report forecasts a widespread pick-up in dividends from UK firms. Assuming BP makes the expected payouts, total dividend payments are set to rise by 10.5%, returning on average 4.4%. Even taking BP's contribution out of the equation, a 9% increase is expected.

Another promising sign is that a more diverse range of businesses in a spread of industry sectors are paying out, so there's slightly less reliance on the dividends of just a handful of big firms.

Charles Cryer, chief executive of Capita Registrars, says: "Although share prices have rebounded, the income on equities is still looking attractive, far ahead of bonds and cash. After a tough two years, investors can look forward to a much better year in 2011."

But the events of the past two years have highlighted the vulnerability of those who rely on either individual shares or equity income unit trusts for their cash flow.

The rules for unit trusts and open-ended investment companies (OEICs) state that each year they must distribute to their investors all the income received from their underlying holdings; so when those dividends fall off a cliff, so too do the fund payouts.

Building up a buffer

This is where income-paying investment trusts come into their own. Because these investment vehicles are actually companies listed on the stock exchange, they're governed by different rules - for example, they are allowed to retain up to 15% of the income received each year and tuck it away in their revenue reserves.

"Investment companies can build up their revenue reserves during the good years to allow them to pay or bolster dividends in difficult years, which is known as 'smoothing dividends'," explains Annabel Brodie-Smith, spokesperson for the Association of Investment Companies (AIC).

Over the years, this gradual build-up of reserves can amount to a tremendous buffer against dividend volatility for trust investors.

Moreover, the ability to draw on revenue reserves means that not only can trusts top up dividend payouts when necessary to ensure investors don't lose out, but many of them actually have a policy of growing their payouts year-on-year, using reserves where necessary. This is known as a 'progressive dividend policy'.

In September 2010, the AIC identified 15 investment trusts that had increased their dividends every year for at least the past 26 years. Top of the AIC list is City of London Investment Trust, followed by Alliance, Bankers and Caledonia.

The average dividend yield across these 15 trusts currently amounts to 2.7%, but Merchants is paying 5.6%, City of London 4.6% and Murray Income 4.5%. All are from the UK Income & Growth sector, which is yielding an average 4.1%.

Of the remaining trusts, eight are global growth trusts that pay less ambitious dividends averaging around 2%, but arguably have the advantage of global sources of income.

Brodie-Smith thinks international income opportunities are improving: "A number of overseas income companies have launched recently, including JPMorgan Global Emerging Markets Income, Aberdeen Latin American Income and Henderson International Income Trust."

The trusts featured above are those with the longest-running records of growing dividends, but there are others with a progressive dividend policy worth considering. Murray International, yielding 3.6%, has maintained or increased its dividend for the last 10 years, as has London & St Lawrence, paying 4.3%.

Others with a similar dividend philosophy have not raised payouts every single year - for example, Scottish American, currently yielding 3.94%, and British Assets, 4.4%.

But be warned: income-hungry investors have been flocking to the best payers, and discounts in the Income & Growth sectors have shrunk dramatically as a result. City of London, for instance, is trading on a 2.2% premium. You may find better value, but smaller dividends, within the UK and Global Growth sectors.

Reinvesting dividends

Even if you don't need to draw an income now and aren't so worried about ultra-reliable payouts, it can be worth holding some dividend-paying investment trusts. By reinvesting your dividends rather than drawing them out as income, you can make a big difference to the eventual size of your portfolio, as the reinvested funds generate both growth and further income.

The latest Barclays Equity Gilt Study shows that £100 invested in the UK stockmarket in 1945 would have been worth £5,721 (no adjustment for inflation) at the end of 2008 if dividends were paid out; if the gross dividends had been reinvested, the £100 would have grown to £92,460.

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