As an increasing number of Australians are approaching or entering retirement, demand is growing for investment solutions that can provide predictable income and more security of capital. With traditionally “safe” investments no longer providing enough income to sustain retirement lifestyles, many investors are considering shares as a source of retirement income.
Traditional low-risk sources of income are now higher-risk and low-return. Term deposits and bonds have often been attractive to investors who want a conservative investment strategy and a predictable income stream. Until recently, many fixed-income funds delivered at least high single-digit returns and Australian term deposits delivered high interest rates.
However, future returns from bond strategies and term deposits are likely to be markedly lower. Current yields from fixed-income funds are now barely positive after allowing for tax and inflation, and it’s very unlikely that bond investors will enjoy substantial capital gains.
Interest rates on term deposits are mostly below 4 per cent – too low to provide enough income for most people to live on or maintain the purchasing power of their savings after inflation.
Looking elsewhere for income
As Australian interest rates are unlikely to rise quickly, many investors have been forced to look elsewhere for income and are finding a solution in dividend-paying Australian shares.
Investing in shares for income works best if company dividends are sustained and grow over the long term. However, dividend growth isn’t guaranteed. At times, companies are forced to cut dividends due to difficult trading conditions and falling profits, and then dividends alone may not meet an investor’s need for income.
So investors who want to use shares as a source of income need to consider ways of earning income from their shares in addition to dividends and franking credits.
One common strategy involves a shareholder selling an option contract over shares they own. The buyer of the option pays a premium in return for the right (but not the obligation) to buy or sell the shares at an agreed price on or before a defined date, depending on how they think the share price will move. The extra income the shareholder earns by selling the option is additional to the dividend and franking credits from owning the shares.
However, building a diversified income stream from shares that includes dividends, franking credits and premium income from trading options is difficult for an individual investor to manage. Companies’ financial characteristics and market conditions and opportunities in the options market are always changing. That’s why many investors prefer to invest in shares through a managed fund, with investment professionals selecting the investments.
Balancing income and volatility
While investing in shares for dividend and other income can be attractive, share prices fluctuate. Some investors may be nervous about exposing their capital to the risk of a market fall.
Equity income funds aim to combine the income from shares with the potential to limit exposure to market volatility and the risk of capital loss. These funds typically invest in large, higher-yielding Australian shares for dividend income. They may also use derivatives to provide another source of income and reduce some of the capital volatility of shares.
There’s a broad range of equity income funds, with varying investment strategies and risk and return profiles. It’s important an investor chooses a fund they understand and that has investment objectives consistent with their needs.
