Cover of MoneyWeek magazine issue no 795, Friday 27 May 2016

How to get a bigger income

25 May 2016 / Issue 795

The “new normal” of below 2% is bad news for income-orientated investors – but accept a bit of risk and there’s still money to be made, says David C Stevenson. Read this week's cover story here.

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Excerpt

Merryn Somerset WebbEDITOR'S LETTER

Merryn Somerset Webb

How to get a return of 5% a year

Was 1999 the high-water mark for equity returns? In the 20 years to then, average real (post-inflation) returns from stocks (dividends plus capital gains) came in at 13.1%. The 20-year moving average has fallen every year since. Last year it was just 3.7%. The last time it was “this rotten”, says Patrick Hosking in The Times, was 1983. The financial industry says that this is a medium-term phenomenon. The overvaluations of the 1990s are still working their way out of the system. Once that is done, all will be well again.

We aren’t so sure – and nor is Hosking. We’ve written here many times of our fears that the problems in the equity market are more structural than anything else – that bad pay incentives are hitting investment and competition; that our biggest companies are just too big to grow; and that real growth companies have stopped listing on traditional markets. If that’s true, it really matters. Morningstar recently released a study on how retirees should approach their pension fund if they want it to last for a full 30 years. The news wasn’t good.

Until recently financial advisers had a straightforward way of deciding how much of a pot you could spend each year. They assumed you had it invested in a balanced portfolio of 50% bonds and 50% equities, and that you got returns on that money roughly equalling the long-term average. You took 4% of it in the first year. Then if you took the same absolute amount, adjusted for inflation every year after that, the money would run out when you were about 90. Job done.

The problem? 4% turns out to be the wrong number for today’s world. Add in costs (the study that originally produced the 4% number ignored them) and the expectation that the average returns of the past really are history, and it’s more like 2.5% – which makes a huge difference. If you had a £500,000 pot, you could once have assumed a safe income of £20,000 a year. Now? £12,000. It’s a miserable business. But it’s also hard to argue with.

You can, of course, have a go at pushing your costs down as far as you can – get them down to 0.5% a year, and on Morningstar analysis maybe you can take out up to 3% a year. But if you can’t get more out of the markets, you just can’t push it beyond that. And it rather looks like you can’t. Turn to our interview in this week’s issue with economist George Magnus, for example, and you will see him forecasting another correction.

Still, we don’t want to be defeatist about this. So David C Stevenson explains how to give yourself a better chance than most of getting a good return from your assets. He talks about what we are calling the “5% solution” – the way he reckons you can get a 5% income on your capital if you are prepared to move beyond a conventional balanced portfolio and take a little risk. It’s worth thinking about – as is the fact that 1982/1983 marked one of history’s great equity-market bottoms.