Back to basics: What is income investing?

-- | 14/04/2021

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Holly Black: Welcome to Morningstar. I'm Holly Black. With me is Dan Kemp from Morningstar Investment Management. Hello.

Dan Kemp: Hello, Holly.

Black: So, we're talking all things income investing today. I want to take it right back to basics first though. What actually is income investing?

Kemp: Well, income investing very simply is when the objective of your investment activity is to generate an income rather than long-term growth. And so, typically, that would be an immediate income. So, money that starts arriving back in your bank account normally just a little while after you've started investing. So, it's a way of turning a lump sum, maybe from a retirement or inheritance or just savings that you have and turning that into typically a regular income which may arrive quarterly or annually.

Black: And why would I want an income from my investments? Why is that important?

Kemp: Well, the traditional reason is that you need to top up your current income. So, of course, people have invested in the past capital that they've inherited or acquired and used that to pay for their day-to-day expenses. So, people tend to think of pensions. And typically, what a pension is, you're just converting that lump sum that you've saved out over maybe a 40-year career into a regular income that's going to see you through retirement. But this is not just for people that have retired. Younger people often have income investing needs as well if for some reason they need to top up their income.

Black: So, we know people do like income investors. Our readers are very interested in dividends or funds with a high yield. But not everyone needs to worry about it. So, when is income investing not important?

Kemp: Well, the reality is it's not important much more than it's important, because even if you do need a regular income from your capital, you don't need to focus your investment on income-producing investments. I think that's one of the challenges that people have when trying to think about the best way to deploy their capital because these days many more people draw off the profits of their capital, the annual gains of their investment if they've made some gains, and use that to top up their income rather than a regular stream of dividends or interest as would have been the case in the past. And in most cases, when people are retiring, they don't want to retain that lump sum all the way through retirement. They want to gradually erode it because it costs far too much to try and have the full income you need to pay for your ongoing lifestyle in retirement and to maintain that capital lump sum. And so, when thinking about your income needs, remember that you don't need an income portfolio to meet those needs. You just need a portfolio that's right for your overall risk and return objectives and is stable enough that you can draw off those profits or some form of income on a reasonably regular basis with a reasonable degree of certainty.

Black: And one thing we hear a lot at the moment is, it's harder to get an income. Why is that?

Kemp: Well, quite simply, interest rates are far lower than they've been in our lifetimes. Many people watching this video will be able to remember interest rates that were above 10 per cent. And so, in that scenario, you can get a very high level of income from your investments, even quite low-risk investments. But now, we're in a situation where even if you lend money to the government for a decade, you're going to get less than 1% income per year. And that is before any tax or any charges as well. So, income rates are very low, which is why people need to think more creatively about how they use their capital to top up their living expenses. But it's really important to understand all of the risks when looking to convert capital to income. There are many schemes out there. There are many new ways of converting capital to income which may not be right for investors. And so, really investigate carefully how you're going to convert your capital into this regular stream of income. It is much more difficult. And so, it's much more tempting to go for something which may be actually higher risk than you think it is.

Black: Dan, thank you so much for your time. For Morningstar, I'm Holly Black.

This report appeared on www.morningstar.com.au 2022 Morningstar Australasia Pty Limited

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