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Do income funds fill a gap in the decumulation phase of retirement?

06 May 2013 Fiona Zerbst
Fiona Zerbst, FAnews Online Editor

Fiona Zerbst, FAnews Online Editor

When we save for retirement we think of ourselves as having a lifetime to do so. But according to Professor Shlomo Benartzi, chief behavioural economist at Allianz, we only really work for a third of our lives because the rest of the time we’re either bei

Small wonder, then, that the retirement industry is obsessively worried about accumulation. But that’s relatively easy to manage compared with decumulation, that phase when you retire and start drawing down your savings, hoping they won’t run out while you’re still alive.

During the accumulation phase, the client’s goal is presumably to save as much as possible and invest as wisely as possible before retirement. You’re working within a more or less predictable timeline. But decumulation means calculating how much money your client will need before he or she dies, and because we don’t know if we’re looking at 10 or 40 years it is incredibly hard to predict which strategy or strategies will work best.

We have a limited time to save and invest, but what happens once we hit retirement? Financial advisors are more than familiar with these questions: When does the client want to retire? How much guaranteed income does he or she need? How much does he or she plan to spend every month so as not to run out of money? How should client’s funds be invested post-retirement, taking inflation risk and longevity risk into account?

Addressing the needs of an ageing population

Equity income funds aim to address the need of investors in the decumulation phase of retirement by providing an investment with a sustainable dividend flow, which is less volatile than ordinary equity but still provides capital growth potential. They achieve this by investing in dividend-paying equities of companies with strong, predictable cash-flows and relatively low capex requirements.

“Funds that offer access to mainly equity income assets have attracted large inflows internationally, because they address the needs of an ageing population which require sustainable income, capital growth combined with lower volatility than ordinary equity,” says Ian Groenewald, CEO of Ora Fund Managers.

The concept of equity income is bound to come into the spotlight when dividend rates became similar or higher than interest rates and investors start to question why they need to rely mainly on interest yielding assets for their income needs and only look to equity for their growth needs. “Globally, most economists expect a low interest rate environment for the foreseeable future and even in South Africa dividend rates are attractive when compared to interest rates,” says Groenewald. “The time may well be right for the equity income concept to become more prominent in the minds of the South African investment community.”

The value of high-quality dividend payers

Dividend-paying equities offer an attractive yield once inflation is factored in, says Stuart Reeve, manager BGF Global Equity Income Fund at BlackRock. “Even a modest rate of inflation will have a ravaging impact on capital over long periods of time, and on any fixed ‘income payment’ investors receive – the latter will be eroded and lose its purchasing power year after year,” he says. “So the question long-term investors and decumulators should ask themselves is not ‘What is the current yield on this fund?’ but rather ‘How about the dividend growth and generated level of income over time?’”

Reeve says high-quality dividend payers should be the focal point – and this means companies with sustainable growth prospects and a willingness to offer a ‘pay rise’ to shareholders over time.

“Stable, more resilient companies are less beset by volatility and this is important because volatility should be reduced compared to traditional equities,” he says. Remember that volatility causes problems if you’re drawing an income – what you really need is consistent and sustainable earnings growth with room for capital appreciation down the line.

Reeve says that many equity income funds have yield requirements or historical dividend growth screens, which actually tell you little about the probability that dividends will continue to be paid and grown in the future. He cautions that investors might want to avoid ‘yield at all cost’ funds – higher-yielding stocks may be at a greater risk of cutting dividends and may therefore require greater scrutiny. Similarly, higher-yielding stocks tend to be in more cyclical sectors, leading to increased volatility.

“We prefer to focus more on future dividend growth, rather than historical,” says Reeve. “For example, high historical dividend yield and growth would have gotten investors into energy and financials at the end of 2007.”

What about the accumulation phase?

Equity income funds may even have a place in an investor’s portfolio during the accumulation phase before retirement, as the compounding effect - if dividend distributions are reinvested, can contribute to a meaningful increase in the total investment value over time.

An additional benefit of equity income is that the tax rate for individuals and trusts on dividend income is only 15% and for companies it is 0% compared to interest income which is taxed at full marginal tax rates for individuals, 40% for trusts and 28% for companies.

Other vehicles that pay dividends

This tax benefit has increased the prominence of funds aimed at providing investors with investments that aim to provide capital preservation combined with dividend income instead of interest income in the South African market over the past decade. These dividend funds are typically aimed at high-net-worth discretionary investors and companies. In fact, they became so popular that some dividend funds were set up as tax structures that swapped interest for dividends in order to cater for the market demand, thereby contributing to tax arbitrage. SARS clamped down on these funds and changed the legislation with the result that only the funds that do not use tax arbitrage now remain.

The dividend funds that remain are attractive for those investors who require capital preservation but prefer to earn dividend income instead of interest income. There are a few options for discretionary investors, because some dividend funds are more volatile than others.

Dividend funds mainly invest in perpetual preference shares (more commonly referred to as listed prefs) and redeemable preference shares. Each of these investments have their pros and cons according to Groenewald, with listed prefs the investor has to be prepared for price volatility as the listed price of these assets vary from day to day. Redeemable preference shares have a set date for redemption, with their dividend rate linked to prime or Jibar. Their price is not volatile but the dividend returns they offer are mostly lower than those of listed prefs. The bottom line, though, is that listed prefs don’t give you much capital growth, and redeemables offer no capital growth, but both generally offer higher and more secure dividend income streams than listed equity.

Dividend funds are aimed at individuals and companies who require no or low volatility investments that provide income mainly in the form of dividends. These funds generally offer higher dividend income than equity income funds, but with limited or no capital growth. These funds are generally used for shorter term investments than those earmarked for equity income funds.

Editor’s thoughts:
If you are in the decumulation phase of retirement, dividend and equity income funds are not bad options from a tax perspective. If you want both growth and income, you could consider this option. If you prefer low capital risk, look for a fund that is limited to redeemable preferences shares and money market investments. What are your views on these funds? Comment below or email

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