Infrastructure, high-yield and emerging market debt and private equity are the three asset classes that can best replace the income that income-seeking investors have been deriving from dwindling dividends, according to a report by LCP.
Investors seeking income have traditionally done this by investing heavily in FTSE-100 companies which pay regular and substantial dividends. Even before the current crisis, this strategy was looking less and less sustainable as it involved more and more people investing in a steadily narrower range of companies and sectors, says the firm. With many such companies now reducing or suspending dividends, investors will need to look elsewhere for income generating assets.
LCP estimates £260bn of DC and private pension assets will enter decumulation over the next 10 to 15 years, creating a pressing structural need to look further afield for income-paying investments. Data from the FCA shows that a withdrawal rate of 8 per cent is most common, giving a high bar for the performance of decumulation investment strategies to support this, says LCP.
Infrastructure investing involves investing in the shares of companies around the world who provide critical infrastructure projects in sectors including transport, energy and utilities; infrastructure assets tend to have long life spans and stable cash flows, earning income from consumers and businesses that need their services even during times of economic hardship.
Investing in high-yield debt and emerging market debt involves buying the debt of a range of companies and countries. Although high yields tend to be associated with higher risk of default, provided that the portfolio is suitably diversified and well-managed, the additional returns from this form of investment will tend to outweigh the loss from individual defaults, says LCP.
Investing in private credit involves investing in smaller companies. Smaller companies can struggle to raise capital through issuing shares or bonds or through bank lending, but asset managers are increasingly finding that they can generate a return by direct lending to such companies. This tends to be a longer-term investment and is less liquid than investing on the bond market but as a result the investor can benefit from an ‘illiquidity premium’.
LCP’s paper shows how an illustrative portfolio combining these three asset classes would have substantially out-performed an index of high-yielding shares from the FTSE-350 over the last two decades.
LCP also calls on the Investment Association (IA) to rationalise its income sectors to make them more useful, and accelerate development of vehicles that permit less-liquid securities
LCP partner Dan Mikulskis says: “For many years, investors have done well by investing in what they know – large FTSE 100 companies paying regular dividends. But the world is changing. Not only has the present crisis led to big falls in dividend payouts, but a strategy of investing in a smaller number of companies and sectors in search of dividends is likely to be increasingly challenging, especially as millions more people are looking for a home for their retirement savings in the coming years.
“Investors and their advisers need to think more creatively about ways of generating income. The good news is that there are many ways of investing, already widely used by large institutional investors, which offer routes to generating income and spreading risk. All have their pros and cons, and advisers and wealth managers need to develop their knowledge and expertise in these sectors. But all have the potential to help individual investors keen to find ways to tackle the problem of disappearing dividends”.
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