UK: Protect Pension Benefits Sooner Rather Than Later

Last Updated: 17 October 2013
Article by Smith & Williamson

A look at alternatives to traditional income – generating assets in a low interest rate world

The fall in UK base rates to unprecedented levels has resulted in negative yields on cash, after allowing for inflation, and negligible or negative yields on most bonds too. Many investors have therefore found themselves forced into higher-risk assets such as equities.

The attractions of infrastructure funds

Because of their extra risks, mainstream equities are not always suitable investments, hence the desire to find more stable sources of investment income. Infrastructure funds are one option. While bearing some of the risks that bonds and equities do, they generally offer long-term income streams, often with some form of linkage to the rate of inflation. The funds that are listed on the stock exchange typically have predictable, long-term cash flows from a range of government-backed infrastructure projects, to which their dividends are linked. The bigger listed infrastructure funds have performed well in capital terms over the last few years, so they're no longer as cheap or as appealing as they were. The majority of these funds are now trading at premiums of over 10% to net asset value. Each tends to come back to the market for additional financing on a fairly regular basis, at which point they raise money at prices much closer to the net asset value – a more favourable entry point. Nevertheless, paying a modest premium for predictable, inflation-linked income that stems from an asset that is relatively low risk and is less correlated to mainstream equities still looks reasonably attractive at a time when ten-year gilts, for example, are yielding less than 3%.

Other alternative sources of income

There are two other main categories.

1. Credit instruments that became mis-priced as a result of market upheaval during the global financial crisis of 2008.

2. New investment opportunities arising as banks have withdrawn from large segments of the business and consumer finance market.

For example, a niche area of growing interest is the financing of bank regulatory capital. In exchange for assuming a portion of the risk in a specified loan book over a given term, ordinarily four or five years, investors can expect to receive a cash payment in the region of LIBOR +13.5% a year, with limited downside.

What are the likely rewards?

Annual cash yields from these types of investment range from around 5%, preferably with some linkage to short-term interest rates or inflation, to 12% or more. Understanding how these yields are derived, and how sustainable they are, is the key to deciding how much to invest. Specialist advice is invariably needed, particularly to understand the risks to capital value.

The risks

You rarely get something for nothing in investment and there are always specific risk factors to consider the further you move away from traditional income-generating assets, such as bonds and cash. Assets with longer maturities which are priced by reference to their yields, for example, are clearly vulnerable to a rise in long-term interest rates. Those which are priced against asset values are exposed not just to the same interest-rate risk but also to the performance of the specific asset class. There may also be tax reasons why a return in the form of income rather than capital gain may not be suitable for investors.

Smith & Williamson Financial Services Limited Authorised and regulated in the UK by the Financial Conduct Authority and regulated by the Central Bank of Ireland for conduct of business rules. Smith & Williamson LLP Regulated by the Institute of Chartered Accountants in England and Wales for a range of investment business activities. A member of Nexia International. Smith & Williamson Investment Management LLP Authorised and regulated in the UK by the Financial Conduct Authority and regulated by the Central Bank of Ireland for conduct of business rules.

The Financial Conduct Authority does not regulate all of the products and services referred to in this newsletter.

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