Pension-phase investors represent one-fifth of Australia’s $2.5 trillion superannuation pool and many seek a regular investment income to supplement the government pension. Generating income is one of their top priorities and for their advisers too.
Dividend income has been popular for a wide range of investors as it has traditionally been a fairly consistent and lower-risk source of income.
That has changed this year. Investors who seek income now need to be aware of increased political risk.
This financial year, investors will need to keep an eye on politics. The Labor Party has proposed changes that, if elected, will see some retirees lose income. While it will not impact on investment funds themselves, it will affect some investors, especially those with SMSFs.
Diversify
For retirees seeking to make up for the lost income, they should consider diversifying their investments.
Diversification is a key principle of investing and is also key to generating good income. Take Telstra, for example. Telstra has been a great income stock for many years, but in 2017 it pre-announced that it would cut its dividends by 29 per cent in 2018. Not surprisingly, Telstra’s share price mirrored the future fall in dividends, dropping 29 per cent in 2017.
On the other hand, the gross yield of the Australian share market has been remarkably stable over the past 25 years, generally averaging around 5 per cent to 6 per cent in gross (of franking credits) income. A diversified portfolio of income stocks or credit exposures can give a more reliable income than investing in a single or very small number of income stocks or credit exposures.
Go global
Retirees, like other investors, are increasingly looking offshore.
There are over 650 overseas companies currently paying dividend yields over 4 per cent a year in developed markets. These include well-known major companies such as Royal Dutch Shell and Exxon Mobil and other lesser-known companies in Europe
There is no shortage of income on offer offshore. Investors just need to know where to look.
No need to hold all year
Many people who invest for dividend income make the mistake of holding the same dividend-yielding stocks all year.
Instead, income investors could consider rotating their allocations across a suite of stocks that pay dividends at different times of the year. Well-timed switching can return dividend income from several companies for the same investment amount, which can increase the dividend yields and franking credits.
While there are costs for trading, retirees generally do not have to pay tax when doing so. However, investors should always check their individual circumstances.
Beware ‘fake income’
While ‘fake news’ is now a common catchphrase, income investors also need to be aware of ‘fake income’.
Real income is the income derived from investments in the form of interest, dividends (including franking credits) and rents.
It should not include realised capital gains as these amount to capital returns, not income returns.
Some of today’s investment opportunities blur the income/capital definition. For example, term annuity ‘income’ payments usually reflect both income and return on capital. Similarly, the ‘income’ distributed from managed funds may represent a combination of real income (interest, dividend and rents) and realised capital gains from an increase in stock prices.
Investors needs to tread carefully around investments that pay out high levels of ‘income’ at the expense of a declining capital value.
Are higher dividend yields riskier?
Higher-yield stocks may actually be less risky than low or zero-yield stocks. Small growth companies often pay very low dividends (if any), whereas companies typically considered safe and mature, such as the Australian banks, may pay handsome levels of income.
However, high historical dividend yields caused by falling share prices could suggest poor prospects for that company and a possibility of future dividend cuts. Income investors need to be aware of these traps.
Similarly, dividends can also be tools for predicting a company’s outlook. For instance, if a company claims it will grow at a rate of 10 per cent, but only raises its dividend by 2 per cent, there could be substantial risk embedded in that growth projection.
It is little wonder that with cash rates and term deposits remaining low, diversified dividend income funds that provide 8 per cent to 9 per cent a year, with low risk coupled with access to capital gain, have been increasing in popularity.
Dr Don Hamson is managing director at Plato Investment Management.