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3 steps to picking the right income fund for you

By Tahmina Mannan FE Tips

Updated on Monday, 26 October, 2015

All the changes made to the UK pensions industry over the past few years, the latest being the greater freedom allowed retirees over their pension pots through Pension Freedom changes – have meant that many investors can now consider different ways to take an income from their investment rather than through the traditional purchase of an annuity.

income

Attention has focussed on income funds as one source of funding for retirement – which means that many more will be seeking out just what is needed to get the right income fund for them.

Fund buyers have typically placed great importance on yield when picking their equity income fund, but there are more effective ways to pick out an income winner.

Stability

One of the most important thing for investors who rely on income should be the stability of the dividend – not yield, according to the analysts at FE Research.

Dividend yield often does not correlate with the actual yield you are likely to receive.

Some investors sell out of funds which dip below a certain yield – but it may be that yield decreases because capital growth has been particularly strong.

What most investors looking to fund retirement through income funds are really after, is the actual amount of money coming in every month or quarter – and this does not have a direct relationship to yield.

In some cases – a fund’s yield could go down and the dividend payout could actually increase.

When it comes to equity funds – yield is often derived off historic yield figures. This means that the yield calculated is the actual amount distributed over the previous 12 months as a percentage of the current share price.

Historic yield is not always a good representation of what can be expected in the future since it will vary with changes in the share price of the fund. If the share price of the fund was to fall significantly over a 12 month period – then the historic yield is likely to appear higher than if the share price had been stable or risen – despite the same amount being distributed.

So when a manger is successful in generating capital growth as well as income – then the historic yield on their fund will be less than promised. This is because the share price will be higher at the end of the 12-month period than at the start, thus reducing the yield despite having met the income objective.

Instead - investors should look at the fund manager’s ‘commitment to the dividend’ instead.

‘Commitment to the dividend’ is the all-important factor. While we all know that past performance is not a true guide to future returns, looking at the fund’s ability to consistently grow or at least maintain its dividend commitments is a good way to gauge whether the fund will continue to provide income at a certain level.

There is no use getting a big payout one year – only find your income cut drastically in the following year!

Capital

Yes you are looking for an income fund – but a manager’s ability to protect capital is also extremely important.

Investors who rely on income are typically cautious in their investment approach and generally shy away from highly volatile funds with the potential for significant loss.

Longer life expectancy also makes capital growth a necessity for investors in retirement. Without it, there is a chance that investors may end up not having a big enough pot of money to draw income from.

Yield

Having said all of the above regarding yield – it should be made clear that yield should not be entirely cast aside and can be used as a last safety net after looking at stability and capital growth potential.

Yield does have a part to play for investors, especially if you are new to the world of investments. For example – if a fund is a stable dividend payer, but is only yielding sub-0.5 per cent – the payout is at least initially minimal for the end investor.

FE Research says that if you invested in a fund many years ago, then you could still be getting a decent dividend even if a fund is yielding very little. If you’re buying it today however, the yield is obviously much more important.

FE Research has found that the funds with the most stable income stream have also been those that have paid out the most income overall.

It always goes back to stability of the dividend. If a manager is committed to paying dividends and has a proven ability to maintain the payout, then you are on the right path.

Lastly, if investors are considering using an equity income fund in retirement – it is worth noting how often a fund pays dividends and when in the year. The typical equity income fund pays a dividend twice or four times a year – which means that it is a good idea to hold a basket of different products so that income is delivered at different times in the year.