How to generate an income from your savings, by Mike Deverell

As the credit crunch continues, pensioners are being hit hard by record low gilt yields and interest rates. For those relying on savings for income, inflation is the biggest danger. At present interest rates on cash (especially after tax) are typically far below inflation, so cash savings are shrinking in real terms.

Low gilt yields are also affecting annuity rates. This means that those using their pension funds to buy an annuity are receiving a much lower income than they would have done in the past.

Bright side

Luckily, annuities are not the only option for pensioners. Drawdown, which was previously only available to those with large pension pots, is now much more affordable and can present an alternative option for smaller pension pots.

Drawdown means your pension fund remains invested and you draw your income directly from it. The maximum you can take out is still limited by annuity rates, but by remaining invested, you can potentially beat inflation.

An appropriate asset allocation strategy is the best way of producing consistent returns and an inflation-proofed income, whether you are investing your pension fund or non-pension assets.

The good news is that, within each asset class, there are still some real income-generating opportunities.

Bonds

Although ten-year gilts yield only around 1.5 per cent a year, there are still plenty of opportunities in corporate bonds.

The Markit Iboxx UK corporate bond index yields around 4.5 per cent a year. This is lower than it has been in the past, but it still represents a decent spread over gilts and cash.

If you are willing to take more risk, then high-yield bonds provide an even greater income. Remember that by buying a bond you are lending money to a company, and if they go bust they won’t repay your loan. Higher-yielding bonds generally have a higher risk of default.

A good way of managing this is to use a strategic bond fund, where the fund manager can choose whether to invest in gilts, investment grade bonds or high yield. For example, the Jupiter Strategic bond fund currently yields around 5.6 per cent a year.

Peer-to-peer lending

Websites such as Zopa and Fundingcircle allow you to lend your money to individuals or companies.

The interest you receive can be much higher than if you left your money in the bank. However, like corporate bonds, your risk is increased as not all individuals or companies will be able to repay their loans.

Zopa says the typical return after charges and actual defaults over the past 12 months is around 5.5 per cent. Fundingcircle advertise a gross yield of 8.8 per cent before fees and bad debts.

Remember that interest is subject to income tax, and that you will need to be able to tie up your money for a reasonable length of time.

Income or capital?

Although generating a high yield is useful, your expenditure does not necessarily need to be funded by ‘income’. There is nothing wrong with funding it from capital.

Say you receive a total return of eight per cent in a year and require five per cent a year to fund your income. Does it make any difference whether you take this from income or capital?

In fact, for non-pension portfolios there is a real tax benefit to taking regular capital withdrawals. You can make capital gains of up to £10,600 in a year without paying capital gains tax.

Say you had a portfolio of £300,000 and made a return of ten per cent. The gain is £30,000 on the total portfolio; however, you only pay tax on gains you crystallise. For example, if you encashed £110,000, you have only crystallised a capital gain of £10,000.

It is therefore possible to take a very high level of regular capital withdrawals without having to pay tax.

Sustainable return

A sensible mix of the above asset classes should be able to generate a total return of over seven per cent a year on average over the long term.

This level of return should be enough to produce a decent income from a mix of yield and capital, and protect against inflation.

Mike Deverell is an investment manager at Equilibrium Asset Management www.eqasset.co.uk