A 100% record
by Doug Brodie
Gas and water bills, council tax and house insurance – some expenses are utterly predictable and though not guaranteed to be charged to us, the rational expectation is that they will be. Technically speaking every company in the FTSE 100 could pay no dividends this year, however the rational expectation is that they will: ‘rational’ because there has always been a dividend despite every crash and crisis since stock markets began. In this way it is rational to believe it is probable that income will be paid even though it is possible that it might not.
There is a price for a guarantee: effectively the issuer of that guarantee (when looking at financial items) has to set aside sufficient capital to deliver that guarantee. That means that no market risk can be applied to that part of the capital. This is why guaranteed rates are always lower than market, non-guaranteed rates. Investment theory dictates that returns must be higher for increased risk, as a rational investor always selects the lowest risk available for a given return. One only increases risk of loss to money in return for a perceived likelihood of a higher return.
When you retire – however you define that – you will want your income to be consistent and reliable, the last thing a retiree wants is to worry about whether the income will be there or not. Our clients measure us on delivery of expectations, and so our research focus starts with consistency, then moves on to annual increases, inflation cover, embedded protection etc. Reliability is the precondition for trust. Like rope.
We measured the annual income payments from 32 trusts from 1974, and then from 1986. In every case payments were made, demonstrating a history of 100% reliability. Not guaranteed, but then we know the difference between probable and possible otherwise we’d never set foot in an aircraft.
Looking at a £100k pot and then drawing income for the next twenty-four years from 1999 to the end of 2022, using the following different drawing strategies:
4% of the fund
£4k fixed each year
4% at start growing by RPI thereafter
Annuity rate
Trust natural income only
… this is the table of the final results, showing the total income paid and the capital value:
Regular readers of this newsletter have read my lines on the great ice hockey player Wayne Gretzky and skating to where the puck is going to be; that holds true with the above as well. The figures tell us what DID happen, which is not the same as what WILL happen, and that is where our interest lies.
The table shows a good example of this: we no longer have any client holdings in Lowland, and that is because of this table:
As clients know, the dividends from a trust are paid from the revenue reserves and not the income the trust itself receives. In Lowland’s case those reserves fell by 42% in 2021, following the effects of the pandemic. In Law Debenture’s case the reserves actually rose by 15% in the same period. Further, you can also see that the dividend per share from Lowland, shown in the green band, actually rose from 60p to 60.25p, a rise of 0.4%, when actual volume of dividends fell from £16,212,000 to £16,182,000.
To us this smacks of a board using financial engineering to cling on to a record of a rising dividend. The board dipped into capital reserves to boost the dividend which we don’t like: on trusts like this we want to see relevant dividend cover – i.e. the amount of dividend paid should be covered by the income received, though we don’t expect that to be absolute. We had a meeting with the fund manager – not the directors – and discussed where their puck was headed. On the back of the meeting, we sold client holdings.
Unlike a dog, an investment trust holding is not necessarily for life.
However an investment trust portfolio, carefully selected and equally diversified, may well be for your life and those of your kids. First of all, let’s just nail the down that harping that costs make it impossible to beat the index: that’s normally an argument put forward by people who have not done their own research, and who rely on the advertising of fund firms like Vanguard and Dimensional -
Secondly, this shows the annual growth of the trust dividends against annual inflation, measured on a 5 year rolling basis (2017 to 2021, 2018 to 2022 etc). You can’t measure inflation on single years because there will always be spikes and you want investments that don’t have spikes in income – you want steady and, frankly, boringly predictable.
The X axis is the 37 years from 1986 to 2022.
The index does pay dividends as well, however the issue creating income this way is two-fold:
firstly lack of diversification, as the FTSE 100 only has, well, 100 companies whereas a portfolio of eight trusts will hold circa 300+ unique firms, all income centric;
secondly, since 2000 the FTSE dividend has fallen 9 out of the 23 years, or 39% of the time.
The income from the trusts is not only higher than the index but also significantly less volatile with no down years at all.
For retirement income, ‘boringly reliable’ is a compliment.
Doug