How to invest for income

Investing for income in the UK is often seen as the preserve of retired savers who use their investments to help fund their lifestyle once they stop working. However, there’s still a surprisingly wide range of income funds available to investors today, offering plenty of options for income investors with various priorities.

Read on to learn more about income investing and how it works.

What is income investing?

Income investing is an investment strategy with the goal of generating a steady stream of income for the investor.

Those looking to generate income from their investments have different needs in terms of:

• the amount of investment income they need
• the level of risk they’re willing to take
• the frequency of the dividend payments they require

For example, younger investors might be looking for something a bit different from their income funds to retired investors who are reliant on their investments to produce an income to live on. Younger investors could consider reinvesting the dividends of an income fund as part of a balanced total return strategy.

Income investment strategy

There's no hard and fast rule to building an income investment strategy, with your choice of fund dependent on what sort of returns you'd like. For example, you can browse AJ Bell Favourite funds and filter the results to find your preferred fund.

But if you're asking yourself 'what are the main types of equity income funds?' And 'what should investors be thinking about when selecting them for their portfolio?', we take a look at six options available to you.

Traditional UK income funds

If you asked a sample of financial advisers to define a traditional income fund, they’d probably point you towards a UK equity income fund.

The UK stock market has a history of paying healthy dividends to shareholders and has long been a bread-and-butter investment for those looking to generate income from their investments.

UK equity income funds are required to produce at least the dividend yield of the FTSE All Share over a three-year period. To that end, fund portfolios skew towards the higher yielding stocks within the UK stock market, and tend to yield around 4% or more, depending on market conditions.

Funds in this category are more likely to pick stocks from the value bucket, as higher yields are typically associated with low valuations. If those valuations rise, and the dividend yield falls, income managers might reinvest in higher yielding stocks instead and hopefully pick up some capital growth to boot.

Total return UK income funds

Some UK equity income funds take a more holistic view of income investing, focusing less heavily on yield, and more heavily on the total returns enjoyed by investors. The term ‘total returns’ refers to the combination of dividends and share price gains or losses.

Total return income funds tend to have a lower yield, reflecting a greater emphasis on capital growth. They can also have a less value-orientated investment strategy, and there are some income funds which prioritise the quality characteristics of portfolio companies over the yield they produce.

These funds may not even sit in the Investment Association UK Equity Income sector because they yield less than the market, so they are for investors who are seeking a mix of income and growth or seeking to diversify their portfolio alongside more traditional UK income funds.

How managers view income and growth is not entirely binary, it’s a spectrum, with some prioritising income more than others who rely more on growth to drive investor returns.

Enhanced income funds

At the other end of this spectrum sit enhanced income funds, also known as enhanced equity income funds. These seek to produce an even higher income than traditional equity income funds, but at the expense of capital growth.

Sometimes called income maximiser funds, they do this by selling ‘call options’ on the stocks held in their portfolio.

The investors who buy the call options pay a fee to the fund for the privilege, which boosts the income available to fund investors. If the price of the stock rises, however, the buyer of the call option gets some of the growth, stunting the growth potential of the fund itself.

These types of fund can be useful for those trying to maximise their income in the short term, but long run total returns tend to be worse than other income strategies because they essentially sell off some of their growth potential.

Global income funds / global equity income fund

While the UK stock market is an obvious home for the equity income investor because of the high level of dividends paid, there are also plenty of funds which invest in companies overseas to generate an income.

Global income funds, which do this on a fully global basis, are likely to come with a lower yield because a large chunk of the global benchmark falls in the US, where dividends aren’t as plentiful, and where companies tend to prefer share buybacks as a way to return surplus cash to shareholders.

More specific regional income funds, perhaps targeting Europe or Asia, for instance, may come with healthier yields, but require a bit more effort to put together a diversified global portfolio than an off-the shelf global income fund.

Investment trusts

Investment trust managers may employ a range of different strategies for producing income, just like open-ended funds.

However, investment trusts can hold back dividends received in the good years to pay out when company payments to shareholders shrivel up because of poor market conditions.

Doing so has led some investment trusts to pay a steady or rising income over many decades.

This smoothing of the income stream from the market can be useful for investors who simply want a regular income that (hopefully) doesn’t dip. However, it’s important to note that an investment trust and an open-ended fund holding the same underlying portfolio, will receive and pay out the same amount of dividends – it’s just that payments from the open-ended fund may well be lumpier because they pay them out as they come in.

AJ Bell’s investment trust select list gives a list of options based on the investment trust market analysis, looking at factors including price, performance, and size, providing a list of selected investment trusts to help you with your research.

Investment trust investors may also be able to buy shares at a discount to the net asset value (i.e., the underlying value of the portfolio), which serves to boost the yield from the portfolio compared to an open-ended fund holding the same stocks.

Multi-asset income funds

More cautious investors who wish to generate an income might consider multi-asset income funds, which invest not just in company shares, but also in bonds, cash, and sometimes property and other assets.

These more diversified portfolios should be subject to less ups and downs than investing purely in equities for income. With rising interest rates having pushed up the yield on bonds and cash, investors don’t have to compromise on income simply to take a more conservative approach to their investments.

Investors can pull together their own portfolio of equity income and bond funds, but many prefer the simplicity and convenience of a multi-asset fund doing this on their behalf.

Other considerations when investing for a monthly income

Frequency of payments

When picking an income fund, investors might also want to think about how often each fund pays out their income.

Often funds will pay out quarterly or bi-annually, but some funds pay out dividends on a monthly basis, which could be a useful feature for those in need of a more regular income stream.

Some monthly income funds will arrange their distributions into 11 equal payments, with a twelfth payment which mops up any surplus at the end of the year, which again might tick a lot of boxes for investors who rely on their investments to generate an income to live on.

Acc vs Inc

Many income funds will offer accumulation (‘acc’) units, as well as income (‘inc’) units. As you might expect, income units pay out dividends to fund holders, whereas accumulation units reinvest them for further growth.

Clearly anyone drawing an income from their investments would probably choose income units. However, those who are investing in income funds as part of a diversified total return portfolio, and aren’t drawing the income, will probably find accumulation units appealing, so they don’t have to reinvest the dividends themselves.

For income funds which don’t offer accumulation units, and indeed for investment trusts, most fund platforms will offer a dividend reinvestment service which automatically buys more units or shares with dividends received, achieving a similar effect to holding accumulation units.

Tax protection

Each year, investors have an annual amount of dividends they can receive without paying tax. However, this so-called 'dividend allowance' has been cut from £5,000 when it was first introduced, to just £500 today. As a result, many people with modestly sized income portfolios are likely to face tax on their dividends, unless they hold them in a tax shelter.

Tax rates for dividends stand at 8.75% for basic rate taxpayers, 33.75% for higher rate taxpayers, and 39.35% for additional rate taxpayers. Income investors may want to use ISAs and pensions to try to shelter as much of their portfolio as possible, where the dividends from investments aren’t subject to this tax.