Investing for income in the ‘new normal’

If 5.25 per cent represents a “new normal” for UK interest rates, what does this mean for income investors? The Bank of England has paused its interest rate rises but, despite signs of inflation easing, many economists believe higher interest rates are here to stay.

For income investors, used to buying shares that deliver dividends or professionally managed funds and investment trusts that do the same, high rates available in cash present a challenge to their strategy. You may be asking yourself or your financial adviser: “What’s the point of being in equities if I can get 6 per cent, or more, in the bank?”

At the time of writing, National Savings and Investments (NS&I) is still smashing the competition with two products for savers prepared to fix for a year: the Guaranteed Growth Bond offering 6.2 per cent interest, and the equivalent Guaranteed Income Bond, which offers monthly interest. 

The savings bank is 100 per cent backed by the Treasury, making it a great option for savers with larger amounts. The Financial Services Compensation Scheme (FSCS), for example, only covers up to £85,000 per institution, so those saving with larger deposits can enjoy further security through the NS&I.

Among mainstream banks, Aldermore Bank offers a two-year savings rate at 6 per cent; with RCI Bank, you can receive 5.85 per cent over three years — the top rates available, according to independent data provider Moneyfacts.

Meanwhile, savers looking for flexibility can turn to Shawbrook Bank, which this week increased the rate on its Easy Access savings account to 5.02 per cent for savers with at least £1,000 to invest. A monthly interest option is available too. 

Incredibly, 8 per cent is also available for savers who want to save diligently up to a maximum of £200 each month. Nationwide Building Society has launched a new regular savings account, the Flex Regular Saver, available to new and existing current account customers at this table-topping rate. 

When the “risk free” rate looks this attractive, you may also be asking if there is any point in taking a risk to diversify into other sources of income?

But even at these high rates, cash has downsides. The consensus is that interest rates are either peaking or have peaked, so 6 per cent is unlikely to be available next year when the bonds or deals mature. So you’d either have to roll over into a lower-paying account, or start investing in equities again.

Meanwhile, unless you’re in a cash individual savings account (Isa), where the rates are slightly lagging behind ordinary savings accounts, you’re likely to be taxed on savings interest over the personal allowance at your marginal rate. The best one-year fix on a cash Isa is from UBL UK at 5.77 per cent, 

The personal tax-free savings allowance now stands at £1,000 for basic- rate taxpayers and £500 for higher-rate taxpayers. And for these people — taxed at a marginal rate of 40 per cent — a 6 per cent return becomes 3.6 per cent after tax. That’s not even close to beating Consumer Prices Index inflation at 6.8 per cent.

Equities can give you an inflation hedge over the medium to long term

Of course, now the Bank has paused its rate rises, the top savings deals may quickly disappear. But if they go, there are other ways to get low-risk income.

Ben Yearsley, director of Shore Financial Planning, says: “I have been taking money out of higher-paying accounts and putting it into gilts.” He is attracted by the tax-free nature of capital growth on gilts, many of which are trading under par, which means there’s a gain on offer if you hold them to maturity. 

“If the majority of the return is tax-free, you’re making more money on gilts earning 5 per cent interest than cash earning 6 per cent,” he says.

But let’s consider what someone relying on income from their investments for many years into the future actually needs. They want to take as high an income as possible today, while seeing the original money invested (the capital) growing to match or preferably beat inflation. And advisers say the only thing that can do that for you is equities.

It’s a case of having less jam today for more jam tomorrow. Yes, you can get a better headline rate on cash today, but you won’t see that improve. Equities, on the other hand, can give you an inflation hedge over the medium to long term.

Take the City of London Investment Trust, famous for raising its dividend every year for the past 56 years by investing in UK equities. It has a dividend yield of just over 5 per cent, so not far off those savings accounts, and if you hold it in an Isa or a self-invested personal pension (Sipp), it would be paid tax free. The trust’s dividend growth of 2.6 per cent in the past year did not beat inflation. However, over the past 10 years dividends from City of London have risen by 41.2 per cent, while the cumulative effect of CPI inflation has been just 26.5 per cent.

Investors in equities, or funds that invest in them, have to be prepared to see their original money fluctuate in value, and riding out downturns is never easy. But the dividends paid consistently from the investments are the reward for that.

Plus, remember that a 7 per cent tax-free return doubles your money over 10 years. Charles Schwab, the US bank, projects US large-company stocks will return 6.1 per cent a year over the next 10 years, compared with 7.6 per cent for international large-company stocks. For UK equities, Job Curtis, fund manager at City of London, says: “I would see dividend growth being in the low single digits. Longer term, you can be confident of total returns of 7 per cent per annum.”

Yes, income investors are spoilt for choice today. But I think the way to look at the current bonanza for cash is that you can finally earn a return on your rainy day money. Most people are advised to hold 6-12 months of income or outgoings safely in the bank in case of emergency. For some families, it could be a large sum of £25,000 to £50,000. And for the past 14 years, you couldn’t earn anything decent on that.

Looking at the potential for cash rates to fall from here, even today’s chart-topping rates don’t feel a good option for the bulk of your long-term savings. You’d be missing out on the potential for inflation-beating dividend and capital growth from shares. For long-term income investors, it’s hard to see a reason to retreat from equities.  

Moira O’Neill is a freelance money and investment writer. X: @MoiraONeill, Instagram @MoiraOnMoney, email: moira.o’neill@ft.com. The author has a holding in City of London Investment Trust