Passive income ETFs - alternative to HYP

[hiriskpaul]

Index linked annuities are the safest way to provide an income. You do not get much for your money, but it is essential to set your expectations at a low level in the present economic climate.

I don't know much about annnuities, I'll admit, but are they not subject to credit risk? The issuer of an annuity is usually an insurance company whch could fail, as Equitable Life did in the UK and AIG did in the United States.

Normally you would expect another provider to take over the book of a failed provider, but if that did not happen the FSCS guarantee 90% of the annuity. Not sure if that applies to all annuities though or just pension annuities.

[Plutus]

Shares are, however, a risky way of providing an income. There are several examples of both capital and dividends falling to less than a half in real terms and taking twenty years or more to recover, particularly in the US where reliable records go back a long way.

What passive investments would you use to provide an income instead of shares or equity ETFs ?

Are Government Bond ETFs and Corporate Bond ETF's currently viable alternatives / hedges to provide an income ?

Others have suggested IT's and OEICs to provide income but the cost of these active funds is much higher ?

....

Investing for high income yield in something like IUKD and high yield bonds funds might work as well, but history tells us that the income produced will not necessarily rise with inflation. Even if it does over the very long term, it is highly unlikely to rise with inflation every year. Ideally you should be reinvesting or holding back some of the income to cope with future shortfalls. This is how some ITs manage to maintain or increase dividends every year.

I think that Warren Buffett has suggested that his wife's retirement portfolio should be 90% broad market tracker and 10% short dated bonds/cash.

[GeoffF100]

There are a number of approaches. One way is to secure adequate secure index linked income from annuities and/or index linked gilts. Anything surplus can then be invested in any want you want - all out risk on frontier markets and a hand picked AIM portfolio if you want as it does not matter too much if the risks do not pay off.

I am sure that is a sensible approach. Back testing does not help much here, other than to warn us of the risks. In particular, strategies that involve re-balancing show up very well if you back test them over times when the markets always recovered, but that will not always be the case.

For the risky part of the portfolio, a world equity tracker is a reasonable choice. Owning your own house is also sensible, particularly given our tax laws.

[TimR]

I think that Warren Buffett has suggested that his wife's retirement portfolio should be 90% broad market tracker and 10% short dated bonds/cash .

I assume that the 10% short dated bonds/cash should be a totally separate amount from your home capital , basic living expenses and an emergency fund and also needs to be large enough to draw upon for an extended period while the stock market is down.

What do Fools think are good passive investments for the 10% short dated bonds/cash (UK investors have Pound value to consider) ? -

My initial thoughts are - US short dated treasury ETF (IBTS) or UK short dated Gilt ETF (GLTS) or a Cash ISA ?

TimR

[GeoffF100]

I assume that the 10% short dated bonds/cash should be a totally separate amount from your home capital , basic living expenses and an emergency fund and also needs to be large enough to draw upon for an extended period while the stock market is down.

You can put your own numbers in here, but I will assume that you can live on £10K p.a. plus the State Pension (many live on just the latter). Downturns in the stock market have historically lasted more than 20 years, so you would need an index linked bond holding more than £200K to sit it out, and a portfolio of more than £2 million. Buffet has deep pockets.

[hiriskpaul]

Going further back things look less rosy. In real terms the dividend income dropped in most years from 1965 to 1976. At that point the income was 59% below where it was in 1965. Capital values were down slightly less in real terms at only -53%

Britain's tax regime in the 1970s was one of the most punitive in the world and triggered an exodus of entrepreneurs and highly-paid stars such as David Bowie, who went to live in Switzerland, and the Rolling Stones, who left to record in the South of France. Higher rate tax of 83% (basic rate around 40%), a 15% unearned income tax ... and in 1968 Roy Jenkins who raised retrospective taxes on income to an all-time record of 136 per cent.

The rise in UK top marginal tax rates (on investment income) from 5% in 1907 to 50% in 1919 and then to 97.5% in 1945 provided an incentive for taxpayers to re-arrange their tax affairs. Investment in companies that paid low dividends but generated high capital growth allowed returns to be converted into capital gains that were either tax-free, or taxed at a lower effective rate, or simply deferred.

Equal weight historic non dividend stock since 1926 and compare to high yield and the two compare. Value weighted and HY outperformed ND by a wide margin. In both cases ND has a much higher standard deviation in yearly gains. Accordingly ND is seen to have a poorer risk adjusted reward. Factor in historic taxes and costs however and things look totally different. Most historic reference data/measures however ignore taxes.

Thread now going off at a tangent, but I have been pondering this. To what extent can the value anomaly be explained by taxation? I did some googling to see if I could find anything about this but came up with nothing. Value (low book value) shares tend to have a higher dividend yield than growth shares, so dividend taxes are a bigger deterrent to holding value shares than growth shares for investors subject to dividend taxes. Assuming a significant proportion of investors were not in some way exempt from dividend taxes, it therfore makes sense for investors to demand a higher total return from value shares than growth shares in order to mitigate the higher taxes.

I had a quick look at US stock returns from the end of 1975 to the end of 2016 both with and without 30% dividend tax. Not definitive by any means, but the results were interesting and shows there might be something in this:



So once a 30% dividend tax is taken into consideration, the Value-Growth premium for this period was reduced from 89bps to 26bps.

[Plutus]

This is an interesting discussion so hopefully the moderators won't mind if it does shoot off topic as I certainly don't mind - I have learned a lot.

I would consider holding an element of gold and I'm tempted to run a small scale permanent portfolio for a number of years, partly as a real life academic exercise and also as a trial run for retirement.

I am slightly nervous about the gold holding though as I don't want to store sovereigns at home, I hear some warnings on gold ETFs and I wouldn't have sufficient quantities to use the facilities at bullion vault in an economical manner.

Any thoughts please? For a relatively small sum of e.g. 2000gbp I would be content to divide between sovereigns, etf, gold miners?, funds etc. but would be more wary of investing 25% of a larger portfolio.

[Plutus]

Thanks 1nv35t I appreciate your replies.

I currently own about 50% of my house, have a local government pension, emergency cash but I am underweight in equities and only own a couple of gold sovereigns.

I am still pondering some of the questions I asked over the new year, it might be best for me to build up a meaningful holding of e.g. VWRL in an ISA and then re-ponder.

[dspp]

In the same way that holding a house deals with paying the rent you can go through the rest of your outgoings and match equities to each item. So gas/oil/elec = hold SSE/NG/RDSB; groceries = hold Tesco, Sainsbury; etc. The point is that for each item you are acquiring an income stream with a divvi that that will likely correlate to future inflation in that stream (that's what you are doing with the housing). After you've done that then you can look further afield - whether index trackers, gold, whatever.

just a thought, dspp

[Plutus]

In the same way that holding a house deals with paying the rent you can go through the rest of your outgoings and match equities to each item. So gas/oil/elec = hold SSE/NG/RDSB; groceries = hold Tesco, Sainsbury; etc. The point is that for each item you are acquiring an income stream with a divvi that that will likely correlate to future inflation in that stream (that's what you are doing with the housing). After you've done that then you can look further afield - whether index trackers, gold, whatever.

just a thought, dspp

That's a great idea and one that I've partially used in the past as it's a great thought that dividends from companies that you pay bills to could help you to pay those bills!

[mc2fool]

In the same way that holding a house deals with paying the rent you can go through the rest of your outgoings and match equities to each item. So gas/oil/elec = hold SSE/NG/RDSB; groceries = hold Tesco, Sainsbury; etc.

So if you have an all-electric household and no car, you should sell up any CNA, BP and RDSB and stack up heavily on SSE & NG?

That's a great idea and one that I've partially used in the past as it's a great thought that dividends from companies that you pay bills to could help you to pay those bills!

Unfortunately my electricity supplier isn't listed and neither is my water company -- nor for that matter is my local council

It's a nice idea but really a very limited one in practicality.

[Hariseldon58]

I'd second the diverse index tracking investment and taking income from capital gains and dividends as required.

There will be a time in the future when 'income' shares fall out of favour and Income Equity Investment Trusts will be available at reasonable discounts and will be good 'value' again, best to take a contrarian stance with patience when it comes to investing outside of the passive world tracker, the starting point for a prudent equity investor for the long term.

Whilst it may not appear a good time to be an equity saver now, my experience that a regular saving programme through good times and bad times has much merit.

[TimR]

I assume that the 10% short dated bonds/cash should be a totally separate amount from your home capital , basic living expenses and an emergency fund and also needs to be large enough to draw upon for an extended period while the stock market is down.

You can put your own numbers in here, but I will assume that you can live on £10K p.a. plus the State Pension (many live on just the latter). Downturns in the stock market have historically lasted more than 20 years, so you would need an index linked bond holding more than £200K to sit it out, and a portfolio of more than £2 million. Buffet has deep pockets.

You would need an index-linked bond paying 5% pa to get £10K pa from £200K.
The short dated Government Bond ETF's (GLTS, IGLS, etc) appear to be currently paying less than 1%.
Is it possible to get a 5% pa (index linked) from a safe passive fixed income investment or would you have to sacrifice the capital and buy an annuity for the 10% part of Buffett's portfolio?

[Lootman]

Normally you would expect another provider to take over the book of a failed provider, but if that did not happen the FSCS guarantee 90% of the annuity. Not sure if that applies to all annuities though or just pension annuities.

OK, but there are still some risks there:

1) You could lose the 10% that FSCS doesn't cover
2) Couldn't FSCS run out of money if we had a financial crisis and several institutions fail at the same time?
3) And then there is the 100% capital loss you (or rather, your Will beneficiaries) take if you die the day after buying the annuity.

I don't see how such a strategy can be seen as the lowest risk.

[GeoffF100]

I assume that the 10% short dated bonds/cash should be a totally separate amount from your home capital , basic living expenses and an emergency fund and also needs to be large enough to draw upon for an extended period while the stock market is down.

You can put your own numbers in here, but I will assume that you can live on £10K p.a. plus the State Pension (many live on just the latter). Downturns in the stock market have historically lasted more than 20 years, so you would need an index linked bond holding more than £200K to sit it out, and a portfolio of more than £2 million. Buffet has deep pockets.

You would need an index-linked bond paying 5% pa to get £10K pa from £200K.
The short dated Government Bond ETF's (GLTS, IGLS, etc) appear to be currently paying less than 1%.
Is it possible to get a 5% pa (index linked) from a safe passive fixed income investment or would you have to sacrifice the capital and buy an annuity for the 10% part of Buffett's portfolio?

If you can get 0% real (i.e. RPI linking with no additional interest) from a 20 year ladder of index linked bonds, you can sell of 1/20 of your bonds for each of the twenty years that the real (i.e. after inflation) value of your portfolio is underwater.

You cannot currently get even 0% real from index linked gilts:

https://www.fixedincomeinvestor.co.uk/x ... oupid=3540

You can get it from a couple of much more risky index linked corporate bonds:

https://www.fixedincomeinvestor.co.uk/x ... oupid=3562

Of course, you will get less in a tracker fund because of the costs and fees.

Buffet's idea here is that you run down the capital of your bond while the equities recover. Sensibly, a small investor should have more than 10% in bonds to allow for big equity bear markets if he needs the money. As I have said, and index linked annuity to provide the income that you absolutely need, plus a world equity tracker makes a lot of sense. I am more risk averse and hold bonds too.

[hiriskpaul]

Normally you would expect another provider to take over the book of a failed provider, but if that did not happen the FSCS guarantee 90% of the annuity. Not sure if that applies to all annuities though or just pension annuities.

OK, but there are still some risks there:

1) You could lose the 10% that FSCS doesn't cover
2) Couldn't FSCS run out of money if we had a financial crisis and several institutions fail at the same time?
3) And then there is the 100% capital loss you (or rather, your Will beneficiaries) take if you die the day after buying the annuity.

I don't see how such a strategy can be seen as the lowest risk.

The FSCS ran out of money a few years ago with the collapse of B&B and other banks. The Treasury lent the FSCS about £20b, which may have been repaid by now with assets recovered from B&B and NRAM. The FSCS could have called on its members for cash, but that would obviously have been extremely undesirable for financial stability at the time. I don't think there is any guaranteed government backstop to the FSCS though and the whole UK financial system could in theory come crashing down if there was a huge failure and financial institutions defaulted on an FSCS cash call. I guess for that reason directly held gilts are safer than any FSCS backed investments/financial products, although the longevity risk is tricky to handle.

Buying an annuity (or an indexed linked gilt ladder) means lower risk to the annuitant, but certainly higher risk to any beneficiaries.

There are other problems with this indexed linked income approach. It is safe from the point of view that income is entirely predictable (barring financial Armageddon scenarios), but for most people would not deliver a very high income or acceptable standard of living. Opting instead to draw an income from assets introduces the risk that the income will over time undershoot the annuity and/or assets be completely depleted before death, but if prudently invested, this risk can be made very small and would be more likely to produce a much higher income, with the potential for a larger legacy. We take a risk every time we walk out the door, drive a car or go on holiday, but we do that because we consider the benefits worth the risk. The same approach can be taken with retirement income. Take on an outside risk of impoverishment for the much more likely outcome of a higher standard of living.

[dspp]

In the same way that holding a house deals with paying the rent you can go through the rest of your outgoings and match equities to each item. So gas/oil/elec = hold SSE/NG/RDSB; groceries = hold Tesco, Sainsbury; etc.

So if you have an all-electric household and no car, you should sell up any CNA, BP and RDSB and stack up heavily on SSE & NG?

That's a great idea and one that I've partially used in the past as it's a great thought that dividends from companies that you pay bills to could help you to pay those bills!

Unfortunately my electricity supplier isn't listed and neither is my water company -- nor for that matter is my local council

It's a nice idea but really a very limited one in practicality.

I expect I haven't explained myself well. Any electrical utility will do as a hedge, so pick the one that is the best investment choice in your opinion. For example I use GoodEnergy for dual fuel gas & elec but I own SSE/NG, (and for good measure 4kW of PV). Even if I switched to an electric car (which I guess I'll do in 5-10 years time) that wouldn't necessarily cause me to dump RDSB either as there's tyres and petrochemicals and lubricants etc used in my life. And in any case once one has hedged each of the big spend areas then there is the option to additionally invest in whatever for general income. That's exactly what I do and it is perfectly practical.

regards, dspp

[mc2fool]

I expect I haven't explained myself well. Any electrical utility will do as a hedge, so pick the one that is the best investment choice in your opinion. For example I use GoodEnergy for dual fuel gas & elec but I own SSE/NG, (and for good measure 4kW of PV). Even if I switched to an electric car (which I guess I'll do in 5-10 years time) that wouldn't necessarily cause me to dump RDSB either as there's tyres and petrochemicals and lubricants etc used in my life. And in any case once one has hedged each of the big spend areas then there is the option to additionally invest in whatever for general income. That's exactly what I do and it is perfectly practical.

Yes, but what you appeared to be saying is that you should seek to cover each major spend area with matching investments that generate the income needed to cover the bills from that area, yes?

Well, when you get an electric car your spend on electricity is going to be vastly more than your spend on types & lubricants, etc, so, assuming even vaguely similar yields, that means that your holding in SSE/NG is going to be vastly bigger than RDSB.

Just thinking roughly about my own situation, my biggest single-item spend is food, which is about 2.5 to 3 times the size of the next two, adult ed courses and council tax (what match is there for those?) and maybe 4 times the size of my electricity bill, 8 times the size of my water and phone bills and about 25 times the amount of my house insurance. So are you suggesting that I should (assuming vaguely similar yields) hold matching sectors in those proportions?

[Itsallaguess]

And in any case once one has hedged each of the big spend areas then there is the option to additionally invest in whatever for general income.

I do like the romantic-idea of paying companies back with their own dividends, but that's about as far as I'd take it. 'Nice-dream', as Thom Yorke sings...

I'm not sure such ideas should actually be allowed to complicate investment decisions, mind. Not sure where you'd stop with that one, and I'm unsure why we'd allow ourselves to invest in 'anything at all' for our general income, but restrict ourselves unnecessarily to other major areas of our spending.

That's not to say that many of these sorts of companies won't end up in our HYP anyway, but I'd not let the 'big spend area'-tail wag the investment-dog in such a way personally....

It's also not to say that I don't like the idea of 'ticking off' big, regular-spend areas of outlay as being 'satisfied' by my investment-income, but I don't need that income to come from specific business-areas to enjoy that; I simply like to see that my outgoings are being eventually covered by what's hopefully a growing income, and it's very satisfying over the years to see such outlays get ticked off. One more small baby-step towards financial independence...

Cheers,

Itsallaguess

[hiriskpaul]

I expect I haven't explained myself well. Any electrical utility will do as a hedge, so pick the one that is the best investment choice in your opinion. For example I use GoodEnergy for dual fuel gas & elec but I own SSE/NG, (and for good measure 4kW of PV). Even if I switched to an electric car (which I guess I'll do in 5-10 years time) that wouldn't necessarily cause me to dump RDSB either as there's tyres and petrochemicals and lubricants etc used in my life. And in any case once one has hedged each of the big spend areas then there is the option to additionally invest in whatever for general income. That's exactly what I do and it is perfectly practical.

regards, dspp

I don't really see how this can work. Your energy bill is a function of the cost of production and transmission of energy. Income from energy utility companies depends on the profitibility of those companies. The futures cashflows of one could easily outstrip the other. Whether an energy company is profitable depends on how well it is run and in areas not subject to monopoly, how well it competes. Energy companies require a lot of capital expenditure as well and returns on the capex are certainly not guaranteed. They also tend to borrow a lot of money, which can be problematic if not properly managed.

A few years ago someone may have invested in Railtrack as a good hedge against the price of their season ticket. That would not have worked out well.

Your PV makes sense though, provided the government does not renege on the subsidy guarantees and you are covered against equipment failure.

p.s. I agree with Itsallaguess and can appreciate the satisfaction of making more out of your utility companies than they are making out of you, but don't delude yourself into thinking the investments are a hedge as they are not. The dividend income from your utility investments could conceivably go to zero, your utility bills will not.