Head to head: Investment trusts versus annuities

Evan Bruce-Gardyne lists five reasons why he thinks investment trusts will play a major role in the new retirement landscape

The retirement landscape has just undergone a seismic change. The raft of regulatory and tax changes introduced earlier this year have made pensions more attractive savings vehicles and altered how people use them to generate a retirement income.

The new rules provide greater flexibility with regard to how and when people release money from their retirement savings and they allow them the opportunity to pass capital down to the next generation.

We believe that investment trusts are well placed to play a key role in this new post-retirement landscape for five key reasons.

1. Inflation-beating income

In the new regulatory environment, those approaching retirement do not have a restriction on how much income they can withdraw from their pension fund.

For those with no or little appetite for risk, annuities are still attractive as they provide a guaranteed income for as long as you live.

Looking at headline interest rates, an annuity might also still look financially appealing.

According to the latest annuity tables a conventional annuity for a 65-year-old yields around 5.65%. At first glance, this compares favourably to the yields paid on many equity funds which tend to be between 2% and 4.5%.

But this is a false comparison. The annuity pays a flat, level income for life and over time the purchasing power of this income will reduce.

Many investors seriously underestimate the effect that inflation can have. For example, with an inflation rate of just 2.5%, the value of an annuity will effectively halve in less than 20 years.

Put another way, an annual income of £5,800 20 years ago would cover the equivalent purchasing power of about £2,900 today.

There are some specific reasons why investment trusts are well-placed to help protect retirees’ pensions from the eroding effects of inflation.

Assets are still invested: Investment trusts generate differing combinations of capital and income which should help offset some of the effects of inflation on a static income.

Long-term track record of dividend growth: There are a number of investment trusts that have good track records of paying rising dividends. Alliance Trust, for example, has increased the dividend it pays to investors for every one of the last 48 years.

Structure: Investment trusts are structured like companies and as such they have independent boards that monitor the fund’s performance.

They have the power to appoint and dismiss the investment manager if investments under-perform.

Furthermore, trusts can use gearing to finance further investment and boost returns. This helps ensure that they are an independent body, with authority to act in the best interests of the shareholders.

Therefore, investors in investment trusts are not just receiving the headline yield, as it appears in the first year that the investment is made, because they are invested in a portfolio that the managers aim to grow in value.

While the yield may remain constant in percentage terms, the actual value of each dividend increases if the portfolio grows.


2. Control of capital

There are, of course, annuities that provide an index-linked income, which currently pay around 3.3% (as at June 2015).

This is clearly more in line with the returns investors can expect from a well-managed investment fund. But collective funds, including investment trusts, offer one critical advantage: pensioners retain control of their capital.

Part of the income you receive from an annuity is the return of capital and when buying an annuity investors lose complete control of their pension fund. If they die within ten, or even 15, years of buying this annuity, the income that would have been paid out is likely to be worth less than the value of their original fund – and what is more, the residual sum can’t currently be left to heirs, unless the annuitant has paid out additional fees for ‘value protection’ on their capital, which will have been deducted from the income the annuity is providing.

By keeping your pension invested, you retain control of your capital and, under the new rules, have more flexibility than ever before in regards to what you can take from it and when – including when you are in retirement.

Keeping your retirement portfolio invested also means clients can pass on surplus funds to heirs.

While this has always been the case, historically there have been punitive tax charges but a part of the changes that have just been introduced will make it possible for pension assets to be passed on to beneficiaries either free of tax or at a rate of 45%.

In 2016, subject to legislation, the tax rate will be the beneficiaries’ marginal rate of tax.


3. Reliable returns

Pensioners who want to ensure their income keeps pace with inflation need a rising income stream. But they also need that income stream to be reliable. With any investment, there is always the risk that market movements can impact on share prices, and companies’ ability to pay a dividend.

However, the structure of investment trusts helps to mitigate against this risk compared to other investment vehicles.

Unlike open-ended funds, investment trusts are not required to distribute all of the income they generate in a year and can retain up to 15% of their gross annual income, which enables them to build up distributable reserves which can be paid out during leaner periods.

This has enabled many investment trusts to maintain, or even grow, their dividend at times when dividend distributions by the markets have fallen.

This ability of investment trusts to smooth income returns is likely to be particularly attractive to retired investors who don’t want to see their income drop – or be forced to spend more of their capital – each time economic conditions worsen.


4. Tax

Retirement planning isn’t just about pensions. Many people use savings, particularly tax-efficient ISAs to help provide an income. The New ISA (NISA) has substantially increased the amount of money that people can save in these tax-efficient wrappers.

For individuals, that annual limit is now £15,240.

Although savers don’t get tax relief on contributions into an ISA, any income taken from these funds is tax-efficient; it doesn’t have to be declared on a self-assessment tax form.

This makes NISAs particularly attractive for those who already have a good pension income as there will be no further tax to pay on income derived from these funds.

Even a small pension will be subject to income tax if income from other sources takes you over the personal allowance.

Large global investment trusts also offer flexibility for ISA savers. These can be used to grow savings prior to retirement – by reinvesting dividends.

Capital can also be used as and when it is needed; investors aren’t constrained by the pension rules, which prevent people accessing the funds before the age of 55. After retirement, these offer an income option for those that need it. There is no need to shift assets from one tax wrapper to another.


5. Diversification

It is one of the principles of investment that higher returns go hand in hand with higher risk. However, it’s important to remember that diversification can help spread these risks.

Global trusts like Alliance Trust offer a good degree of diversification, not only because they hold a range of different companies within their portfolios, but also because their mandate allows them to invest in companies from all over the world, so they can seek out the best companies, wherever they are listed, rather than being constrained by sector or market.

Evan Bruce-Gardyne is investor relations director at Alliance Trust