Income and capital

Income and capital

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One of the articles of faith for the super-wealthy used to be never to spend principal and instead to rely on the income that it generates.  While this might have seemed like a sensible approach if your name were Vanderbilt (or indeed Jane Austen’s Mr Darcy in Pride & Prejudice) and the income on the family fortune would be adequate to meet your spending needs, most of us inhabit more modest circumstances.  A more considered approach is therefore worthwhile.

We recently saw a long-standing client who has enjoyed a long and successful career in business but who is now anticipating the winding down of his non-executive directorships.  He will therefore experience a reduction in his income, although not his expenditure.

When we discussed with him how he will fund his continuing expenditure, he expressed concern at the idea of drawing on his accumulated capital as to date he has always been adding cash to his various investments and he was uncomfortable with the idea of it.

Like many savvy investors, he is familiar with the importance of reinvested income to the long term returns of an investment portfolio.  Indeed, according to one of the authors of the annual Barclays Capital Equity Gilt Study, which looks at UK market returns back to 1899, around 90% of the total annualised post-inflation return is attributable to reinvested dividends and only around 10% to capital growth.  This is simply a function of the maths of compounding as each year’s reinvested dividend increases the size of the pot on which the following year’s income is based.

However, there are several reasons why most private investors might usefully take a different view of things.

One is simply tax.  The ways in which investment income and realised capital gains are taxed can vary over time (and have done in the past) depending on the agenda of the government of the day,.  However, for anyone paying more than the basic rate of income tax the former is currently taxed rather less favourably, as can be seen below.

Clearly, allowing tax to determine an investment strategy is rarely a sound starting point as taken to extremes it could lead to buying only investments that are expected to make a loss.  However, tax is a fact of life and few investors are in a position to ignore it entirely so it is sensible at least to consider it when making decisions as to how a portfolio is structured and managed.

Another is that limiting the rate at which you extract cashflow from a portfolio to its yield is necessarily constraining the important bit, which is meeting whatever your objectives are.  While the yield which the portfolio happens to deliver may be consistent with your need for cashflow, there is no logical reason why it should be.  In any case, the yield from different shares can vary significantly, based on such factors as the growth stage of the underlying business and the focus placed on income in the region where the company operates.  A further factor is that yields move in opposition to changes in a company’s share price so when the share price has risen, its yield will typically have fallen.  By extension, a company whose share price has taken a battering from investors will exhibit a high yield relative to the market – investors requiring high income from their portfolio may thus be tempted to overweight such companies and thus skew their portfolio towards riskier assets.

Finally, there is the likelihood that, unless you have acquired your wealth by winning the lottery or inheriting it, your wealth is the product of many years of hard work on your part.  Certainly that was the case in this instance.  Unless you plan to leave it all to someone else, it is probable that, consciously or not, you spent your investing life aiming towards the time when paid work became optional.  For this to happen requires converting human capital to financial capital and having achieved that, you are now in a position to use it to support your lifestyle for the remainder of your life.

Of course taking withdrawals of capital from a portfolio will, over time, erode the value of the asset from which future returns are generated, so care needs to be taken to do so in a controlled manner.  The rate at which such erosion is appropriate will vary according to your specific circumstances, not least how long you require it to last.  An annual withdrawal rate of 4% of the initial value will deplete an asset with no growth after 25 years but that may be less of an issue if you are 95 than if you are 60.

Since most people have affairs which are at least slightly more complex than one asset and a fixed expenditure need, the value of being able to model the outcome of various possible scenarios when determining how best to generate the necessary cash becomes apparent.  If you don’t want to do this yourself, you might want to consult a financial planner.