Using Capital to Supplement Income
Most investors drawing regular funds from their portfolio only withdraw the natural yield, which is the interest and dividend income from the investments. Whether it is sensible and sustainable to regularly withdraw capital in order to supplement the natural yield has always been a topic that has divided opinion. As global equity markets continue to rise and with bond yields at low levels this yield has compressed, moving the once easily achievable natural yield further out of reach. As a result, we feel that withdrawing some capital from the portfolio to supplement the natural yield can benefit a portfolio for a number of reasons:
Growth Prospects: Companies that have higher pay-out ratios (the ratio of earnings that are distributed via dividends rather than being retained) generally have less attractive growth prospects, hence the decision to distribute income rather than invest in the business. For those with a long term investment horizon, sacrificing a high starting yield for a lower one with greater growth prospects can result in better income returns over the long term.
Portfolio Diversification: Accepting a lower natural yield and supplementing this with the gradual sale of capital allows for a more balanced portfolio. The classic income sectors of Utilities, Telecoms and Oil & Gas are typically ex-growth industries and while many companies within these sectors offer high initial yields, the growth prospects are likely to be below that of the wider equity market. It is also worth noting that stocks that come with very high initial yields may reflect concerns around the dividend sustainability.
Tax Benefits: The current rate of Capital Gains Tax for basic rate tax payers is 10% and 20% for higher rate individuals once the £11,300 annual allowance (2018/19 £11,700) has been utilised. Dividends however are taxed at 7.5% for basic rate, 32.5% for higher rate and 38.1% for additional rate payers. With the annual dividend allowance being reduced from £5,000 to £2,000 in the 2018/19 tax year, dividend income will be less tax efficient. Selling down some of the capital is likely to be more tax efficient than investing in higher yielding investments for most taxpayers. Paying some capital gains tax is ok!
Share Buybacks: An option commonly adopted by a number of businesses to use excess cash in order to repurchase shares instead of paying a dividend. This technique reduces the number of shares in issuance, increasing the earnings per share which should result in a higher share price. An income focused strategy is likely to mean that companies adopting buyback programs instead of dividends are not likely to be included in portfolios.
In investments there is no such thing as a free lunch and electing to withdraw capital does come with some disadvantages such as being a forced seller when markets decline and incurring higher trading costs. A sensible cash float can help to mitigate some of the drawbacks.
While there are both advantages and disadvantages to the strategy of withdrawing capital we think in many cases it should be carefully considered as a viable option. If you have any questions or would like to discuss possibly implementing this strategy please get in touch with your investment manager.
21 February 2018