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Understanding capital and income

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AR011133 10/2018

The return on most investments (or ‘assets’) comes from two sources:

  • The capital

  • The income (or ‘yield’)

For example:

  • the cash in a bank account is the capital, and the interest is the income;

  • the market value of a buy-to-let property is the capital, and the rental is the income; and,

  • the market value of shares is the capital and the dividend is the income.

With most investments, the one exception being cash, the value of the capital fluctuates according to its market value. We are all used to the fact that house prices go up and down, and the same is true of the other main types of investment, namely shares, bonds and commercial property.

Although the capital value of investments may swing around quite wildly, especially the value of shares, that may not be as big a concern if the income from those investments remains relatively stable.

For example, if I bought a UK 10-year government bond today(1), the price I pay for the bond would be £101.26, and I would receive a coupon of £1.63. The running yield, or effective rate of interest would be 1.61% (£1.63 divided by £101.26). I also know that if I hold the bond until maturity in October 2028 that I will get the £100 face value back.

However, between now and 2028, the market price of that bond might fluctuate quite a bit. For example, the price could fall to £80 or less, or rise to £120 or more. But if my aim is to live off the 1.61% interest, the market value of the bond is of little consequence because I know that I will receive the same rate of interest regardless and get £100 back in 10 year’s time.

For other investments such as shares and property, you won’t get the same certainty of income as you do from government bonds. Unlike government bonds, the dividend, rental income or rate of interest on cash deposits could fall or rise from its starting amount.

However, the initial income I would get from an investment in shares or property should be a lot higher than the 1.61% I would get by investing in 10-year UK government bonds.

For example, if I held all the shares of the 600 companies that make up the FT All Share Index – through an index-tracker fund, for example - the dividend yield was 3.59%(2) at 31st July 2018. In other words, the income received over the previous 12 months to 31st July 2018, would have been £3.59 for every £100 invested at the share prices on 31st July 2018.

A yield of over 3.5% seems quite good given that instant access cash interest rates are only around 1.4% (3). However, there is of course the risk that the dividend income from shares might fall, which could be an issue, given that this is the income you rely on in retirement to pay the bills. 

Some advantages and disadvantages of living off investment income during retirement

Advantages

Disadvantages

You don’t have to worry about how long you are going to live, if you can happily live off the investment income indefinitely. However, investment income could reduce, so you would have to be comfortable with that risk.  The relative value of income could also fall if investment income fails to keep pace with inflation.

You are living off investment income only, so relative to solutions such as annuities that are made up of capital and income, your initial income is probably going to be lower.

You still have capital to pay for unseen future events such as the cost of long-term care.

You must still pay the administration and fund management charges associated with keeping the money in your pension. This will reduce the income you can safely take by between 0.4% and 1%+.

You can pass any remaining capital to your spouse, partner and family on your death.

Your income could fall if the rate of interest, dividends or rental income within your investments falls.

Short-term fluctuations in the capital value of your investments is less of a concern. What is important is the income that your investments generate. So the key concern with this approach is that the income from your investments falls.  

If you invest in a limited number of shares or properties, you may suffer a disproportionate fall or rise in income based on the fortunes of those investments.

Your income could rise if dividends, rental income or rates of interest on cash deposits rise.

Dividends and rental income can be received sporadically throughout the year, which doesn’t match the way you spend money.

 Making sound financial plans is important and the decisions you make can be life changing. If you need support, you may wish to speak to a financial adviser. If you do not have one, you can find one near you at www.unbiased.co.uk. Whatever advice service you choose, there will be a charge. The amount and payment terms will be explained to you by your adviser.

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