Investing for income
Weigh up your income needs
Types of income investments
How dividends work
Diversification
Investment income and tax
Listed property
Indexing and investing for income
Investing for income
Most people have times when a little extra income would not go astray. Not only does it help pay the bills, income can give us the freedom to take time out and focus on what's really important. Taking a break from work to raise children, going back to university, investigating a sea change or launching a new business idea are all times when we could use an additional income stream.
Australia has enjoyed a low inflation, low interest rate environment over the past decade. While this is great for the economy it has implications for people who rely on interest from their savings to fund their living expenses. Many people who fall into this category, like retirees who may not have had the benefit of super all their working lives, have had to rethink their investment strategies.
Many people believe the only way to earn an income from their investments is through cash and fixed interest investments. However, there are alternatives. Some shares and listed property trusts can provide a tax-effective income in the form of dividends. The good thing about these assets is that they can also provide growth over time, so your savings can keep ahead of inflation.
This Plain Talk® guide explains how you can generate income through investing. It explains the different types of income investments, factors impacting their returns and the importance of tax.
Weigh up your income needs
There is a myriad of income-producing assets to choose. The right type of income stream for you depends on your investment objectives and timeframe, tolerance for risk and tax position.
Income and capital growth don't need to be mutually exclusive. You can have your cake and eat it too. The right mix of income and capital growth depends on whether you need immediate access to your money or you would prefer to have some income now while growing your investments over time. The table below shows the average annual returns for each asset class over the 20 years to 30 June 2007.
Income assets like bonds/fixed interest and cash are known for their steady and reliable income producing capabilities. While their returns tend to be more stable than growth type assets, they don't offer the same income and capital growth opportunities.
While shares and property primarily provide returns in the form of capital growth, they can also provide a tax-effective income stream. It's important when you are looking at growth assets for income that you look for high yielding investments that have a history of paying dividends. Property and share investments also provide the potential for a growing income stream. For example, property owners may increase rents or company profits may increase over time. Over the longer term growth assets are also a good hedge against inflation.
Usually, the longer your investment timeframe the more you can invest in growth investments. Of course, if your primary need is for income and you need quick access to your money, it might be best to stick to income producing assets such as fixed interest and cash.
For many investors a mix of income and growth assets offers the best investment alternative. With a diversified portfolio of investments, returns from better performing investments can help offset those that underperform.
Types of income investments
Many asset classes offer steady income - cash, property (direct and listed), fixed interest (such as government and corporate bonds) and high-yielding shares are all examples. Some of these asset classes also offer a combination of income and capital growth.
The table above shows the types of returns you can expect from each asset class.
Each asset class offers different characteristics, benefits and levels of risk (see table below). Your attitude to risk is an important factor when deciding where to invest your assets.
The major characteristics, benefits and disadvantages of each asset class are outlined below.
Cash
Cash has the lowest risk of all asset classes. Cash investments include, for example, term deposits, money market securities and cash management trusts. Term deposits usually offer higher returns than traditional bank accounts to compensate for the longer investment term. Usually, the higher the rate the longer you need to lock your money away or the higher the risk.
Cash funds seek income, liquidity, and stability of returns by investing in short-term money market investments (that usually mature in 12 months or less). The short-term nature of cash funds makes them less volatile than other types of funds. Cash funds provide the potential to earn higher returns than bank accounts and term deposits.
Income distributions from cash funds can vary greatly as interest rates move up and down. Typically, investments in cash funds are not capital guaranteed. While it is unlikely that the value of your capital will fall, cash funds cannot provide a capital guarantee.
The returns on cash investments are intrinsically linked to interest rates and inflation. The below chart shows cash returns (as measured by the UBS Australian Bank Bill Index) have remained steady over the past decade given our low inflation, low interest rate environment.
Fixed interest
Fixed interest is a low to medium risk investment suitable for investors with a timeframe of three years or more. Fixed interest investments include government bonds, corporate bonds, debentures and notes. As their name suggests, they pay a fixed rate of interest at regular intervals.
Bonds operate like an IOU, whereby you lend your money to the issuer for a set period of time, in return for a fixed rate of interest paid over the term of your investment. Your investment, or capital, is then paid back to you in full at the end of the investment term.
Fixed interest investments usually have longer investment terms than cash investments. Available terms can vary. Australian bond maturities range from one to 10 years while US bonds can extend up to 30 years.
You can invest in fixed interest investments directly or through a managed fund. Managed funds provide a way of accessing a diversified portfolio of securities, which can include a mix of Australian or international government and corporate fixed interest investments, or a combination of both.
The international bond market includes over 3,000 securities compared to around 300 in the Australian market. Investment in both international and Australian bonds has two major benefits for investors. It increases diversification, which lowers risk, and it provides opportunities for enhanced returns without resorting to lower grade, higher risk debt.
Bond issuers
Fixed interest investments can be issued by the Commonwealth Government, state governments, semi-government authorities, banks and other corporations, both locally and overseas, to raise capital for projects. Credit ratings provide a good indication of the risk level associated with the issuer.
Bond issues are rated by independent rating agencies like Standard & Poor's. The higher the rating the less likelihood of the issuer defaulting on repaying your capital. AAA is the highest rating awarded for long term issuers while BB and below is the lowest and is usually given to more risky or speculative investments. Usually, the higher the risk, the higher the yield.
The three main types of bonds are:
1. Government bonds - issued directly by a government and are explicitly guaranteed. For instance, in Australia the Federal Government issues commonwealth securities to help pay for major government projects;
2. Semi-government bonds - not issued directly by a government but might have a direct or implied guarantee. For instance, state governments and other entities that have a government guarantee, (like the World Bank), issue bonds to support their financial needs or to finance public projects; and
3. Corporate bonds - issued by large public companies to fund expansion and other major projects. Corporate bonds differ in two important ways to government bonds - yield and credit quality. Generally, corporate bonds are thought to have a higher level of risk than government or semi-government bonds, so they typically offer higher interest rates.
There are also hybrid securities that possess characteristics of both shares and bonds. While they pay a higher yield than other fixed interest securities they do carry higher risk. They pay a regular rate of return, like bonds, until the specified end date. At the end of the investment term the investor can convert their investment into the underlying share.
The chart above shows the historical returns for Australian bonds. Income from bonds can fluctuate and overall returns can be negative. Fixed interest securities can be traded on the secondary market before their maturity. This is usually the domain of professional investors such as the large banks, brokers and fund managers. Bonds can provide capital growth (and loss) when sold prior to the maturity date for a higher (or lower) price. When interest rates rise bond prices fall, and when interest rates drop, bond prices increase.
Property
Property investment is available via direct property, property securities and managed funds. Property is a long-term investment with higher risk than fixed interest investments but lower risk than shares.
Direct property investment is the traditional method of investing for income. It can offer steady rental income, tax breaks via negative gearing and capital appreciation. But, there are drawbacks. It takes time to buy and sell: building a diversified property portfolio is an expensive exercise; your property exposure is limited to one sector; locating and keeping good tenants can be difficult and there is always ongoing care and maintenance. There is also the risk of capital loss and lower rentals during times of oversupply.
For people who want the benefits of property investment without the hassles, listed property trusts could be a better option. Returns from listed property can include income in the form of rent received from the underlying properties and capital growth (or loss) from changes in the value of the share price. The Australian listed property market includes thousands of properties across the retail, diversified, office, industrial and hotel and leisure sectors. Property trusts hold a basket of properties in one or more of the property sectors.
Managed funds can invest in single or multiple listed property sectors. Some even include some exposure to direct property. The main benefits of managed funds are that you can invest in properties you would not be able to access directly yourself and you can hold a diversified portfolio of properties for a relatively small initial outlay. The value of assets held by a property fund can fluctuate and income levels are not guaranteed.
Shares
Shares are generally considered a high risk and high return investment and are suitable for longer-term investors. Historically, Australian shares have provided long-term growth well above inflation.
While shares are primarily a growth asset, they can also provide a good source of income. Most companies distribute a proportion of their profit in the form of dividends. Some companies, like those in the mining sector, may retain dividends to fund expansion or exploration plans. That is why it is important to examine the dividend history of a company before you invest. Companies that pay high dividends tend to be blue chip companies like those in the banking sector.
Another way to access these types of shares is through a high yield or imputation style managed fund. These funds are biased towards companies expected to pay greater cash dividends and franking credits. As a result, they tend to provide a higher income return than the average Australian shares fund.
International shares do not provide the same income benefits as their Australian counterparts. Income generated from international assets is generally in the form of realised capital gains rather than dividends.
How dividends work
Shareholders receive a cash dividend along with franking credits (equal to the amount of tax paid by the company on its profit). The franking credits are then used to offset income tax payable on an individual's annual tax return.
Dividends are declared as an amount per share, for example 15 cents per share. The company's directors decide on the size and frequency of the dividend. As companies grow and become more profitable they typically increase dividends. Dividends are usually paid twice a year - the interim dividend paid after the half-year profit and the final dividend paid after the full-year profit.
Share returns quoted cum dividend - simply means the dividend has been included. Three business days before the books close, the shares will be quoted ex dividend - again, simply meaning a dividend has not been included.
The total dividend for the year (the sum of the interim and final dividend payments) is used to calculate the dividend yield - the theoretical return on shares if the investor buys at the market price. It is calculated by dividing the dividend per share by the market price and then showing the result as a percentage.
The chart below shows the historical dividend yield for Australian shares and the average dividend yield over a 20-year period. The long-term average dividend yield gives an indication of the expected long-term yields from the sharemarket.
It is important to note that actual yields can change dramatically from year to year and vary from company to company. If company profits are not growing, dividends are likely to be stable and if profits fall, a company may have to reduce dividends. Investing in a diversified imputation or high yield style fund can lessen this impact.
Dividend yields
The dividend yield is calculated by dividing the annual dividend paid by the current share price and expressing this as a percentage. For example, company ABC pays an eight cent interim dividend and seven cent final dividend, for a total dividend of 15 cents. It has a $4 share price.
| The dividend yield is: 8 cents + 7 cents = 15 cents ÷ 400 cents ($4) x 100 = 3.75% |
The proportion of earnings paid out in dividends is called the payout ratio. If a company earns $1 a share and pays a 40 cent dividend, the payout ratio is 40 per cent. This ratio is an important investment tool. It is one way to measure a company's dividend policy and compare it with other companies and the industry average. It also reflects the company's judgment of how much of the profit should be returned to shareholders and how much should be reinvested.
Current dividend yields for companies listed on the Australian Stock Exchange are published in the sharemarket sections in most daily newspapers.
Maximising your income return
Generally there are two ways to maximise your income return. You can add shares or property to your portfolio or you can invest in fixed interest investments with longer investment terms or lower credit ratings. Both options will change the risk/return profile of your portfolio.
The chart below compares the cash rate, 10 year government bond yield and the dividend yield from the Australian sharemarket against the inflation rate. As you can see the cash and bond yields are only marginally above the rate of inflation.
When you compare the returns on an after tax basis, the reasons for including some Australian shares or property in your portfolio become clearer. For instance, bonds usually provide higher returns than cash in the short-term but require a time commitment of around three years.
On the other hand, shares can provide higher returns (both income and growth) than other asset classes and are generally more tax effective. Coupled with higher return potential is a commensurate increase in risk.
Diversification
Spreading your money across a range of investments is one of the best ways to reduce your exposure to market risk. This way you are not relying on the returns of a single investment. Investment markets move up and down at different times. Finding the right balance is a matter of weighing the risk characteristics of various mixes of assets against your time horizon, goals and the returns you desire from your portfolio. A balanced portfolio of income-producing shares, property, cash and bonds will provide you with a good combination of income for today, growing income for the future and capital growth over time.
Your investment timeframe
If you need income for a long period (e.g. for retirement) you should be aware of the effects of inflation on the buying power of any income. Even in today's low inflationary environment it remains an important consideration. If your time frame is 12 months or less, investing in shares is probably not a good option, because they can be volatile over short time periods. The table below shows the recommended minimum investment timeframes for each asset class.
Investment income and tax
Tax can make a big difference to the amount of income you get to keep. Over the 10 years to 31 December 2006, the effective tax rate for a person on the top marginal tax rate for Australian shares was approximately 21 per cent, residential investment property and listed property around 26 per cent and fixed interest and cash around 49 per cent. That is why it's important that you understand how tax impacts your investments before you invest.
Fixed interest and cash income
Because of their nature, all income from fixed interest and cash investments is treated as taxable income and taxed at the investors' relevant tax rate. This may not be an issue if you are on one of the lower marginal tax rates, but for those on the higher rates it means almost half your income could be eaten by tax.
Dividend imputation
Shares can provide tax benefits in the form of franking credits. Shareholders receive a cash dividend along with franking credits (equal to the amount of tax paid by the company on its profit). The franking credits are then used to offset income tax payable on an individual's annual tax return. It is important to note that on the tax return the full dividend (called the 'grossed-up dividend' and which equals the cash dividend plus the franking credits) must be declared as income with the franking credits used as a tax offset.
Because the corporate tax rate in Australia is 30 per cent, the maximum imputation credit attached to a dividend will be 30 per cent of the grossed-up dividend. If a dividend has an attached franking credit at the 30 per cent company tax rate it is referred to as 'fully franked'. Sometimes, depending on how much tax a particular company has paid on its profits, the 'franking rate' will fall below the 30 per cent mark and investors will only receive a partially franked dividend. Companies like the major banks pay fully franked dividends, an important reason why they have been popular with investors since dividend imputation was introduced.
Investors with a marginal tax rate of 30 per cent who receive a fully franked dividend can effectively receive their distribution totally free of tax. Even better news for those whose marginal tax rate is below 30 per cent is that imputation credits in excess of income tax liability may be refunded in cash by the Australian Taxation Office (ATO).
The following example shows the net impact of fully franked dividends on an investor's income based on different marginal tax rates.
Franking credits work in a similar way in a share fund. The credits received from the underlying assets are taken into account and a franking level for the fund is calculated. The credits are passed on to unitholders, together with any other income distributions.
Your fund manger provides you with a tax statement after the end of the financial year, which details franking credits and other distributions you received and this should be used to complete your tax return. Any excess franking credits over your total tax payable are refundable in cash from the ATO.
Listed property
Australian listed property trusts offer tax advantages to investors in the form of tax deferred income distributions. Tax deferred income distributions arise when taxable income is less than accounting income. In particular this situation arises in relation to building allowances and depreciation claims that are greater for tax purposes than for accounting purposes.
Simply put, the tax deferred component is not included in the investor's assessable income in the year of receipt, but is deferred until the investor sells the investment. When the investment is sold, the tax deferred distributions are reflected in the calculation of capital gains. Where the investment was held for more than 12 months, any gain may be eligible for the capital gains tax concession of up to 50 per cent. Other assessable income and realised capital gains are treated in a similar fashion to Australian Shares.
Indexing and investing for income
Indexing can be an effective investment strategy for income-seeking investors. By adopting a 'buy-and-hold' approach the cost of investing can be significantly reduced over time and lead to better returns in the long term, especially on an after-tax basis. Because index funds invest in all or most of the securities in an index, they provide diversification, which means lower risk.
Unlike active fund managers, index fund managers don't try to outperform the market. Rather, they invest in all or a representative sample of the securities in the index and let markets do their work over the long term.
Historically, few active fund managers have been able to sustain above benchmark returns after costs over the long term. In March 2006, Vanguard commissioned research house Morningstar to conduct a Skill versus Luck study.
Morningstar surveyed 369 managed funds across the four main sectors to determine fund managers' skill levels by analysing the level of excess returns over the relevant benchmark and the consistency of outperformance on a monthly basis. Morningstar found that only 39 per cent of funds in the sample produced consistently positive excess returns over five years to 30 June 2005. Fund returns were calculated net of ongoing expenses, and compared to the unadjusted capital market index returns for the relevant sector. (Results would have differed if more or less funds were surveyed.)
The indexing pioneers
Vanguard pioneered the concept of indexing, introducing the first retail fund in the US in 1976. Vanguard has since become one of the world's most experienced and successful indexing specialists. In fact, the Vanguard Group manages more than $1.4 trillion worldwide.
Vanguard recently celebrated 10 years in Australia, managing more than $65 billion on behalf of our Australian and international clients as at 30 June 2007.
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