Investing for Income Series: Laying the foundations for income strategically
Income is critically important to supporting an SMSF trustee's lifestyle, especially during retirement. In the second article of our Investing for Income Series, we explore how trustees can set up an investment strategy geared for income.
Income is top of mind for self-managed super fund (SMSF) trustees.
Before fund members retire the fund must be structured in a way so it is able to produce sufficient income for them once they have retired.
When members are retired, income becomes even more important given it supports their lifestyle.
AMP financial planner Mark Borg says trustees should start thinking about income as soon as the fund is set up.
Ongoing contributions should be the focus for members still in accumulation phase.
“Funds derive income even when they are in accumulation phase through contributions. So it’s essential the investment strategy takes into account the need to handle small amounts of money on a regular basis,” says Borg.
With this in mind, an investment strategy that drives income must allow for investments in cash or other similar asset classes that can easily accept such funds.
When making plans around income, it’s always essential to keep in mind the overall goal of the fund and the needs and risk profile of the members.
When it comes to risk profile considerations, the idea is to strike a balance between assets that produce regular, reliable income but don’t display the potential for high capital growth and assets that will generate capital growth but that don’t have as much income-generation potential.
In general, assets that have higher capital growth but lower income-producing potential are considered higher risk than assets that don’t display the same levels of capital growth but that pay higher levels of income.
“Once this is understood then it’s about investing in an appropriately diversified portfolio of income-producing assets that match the fund members’ risk appetite and investment goals,” Borg adds.
An investment strategy to drive income should be based around choosing assets that provide strong income streams. Here are some examples:
- Infrastructure investments with low debt levels: these investments often have government-guaranteed income streams and operate monopoly markets
- An investment property with a minimal or no mortgage that produces income as rent
- Shares that pay high dividends
- Term deposits
Says Borg: “It is important to note that most assets can pay a reasonable degree of income, it’s a case of ensuring you make the right selection when going through the asset allocation process.”
Unencumbered assets that generate income, such as a wholly-owned investment property that provides a regular income stream through rent, generally offer a lower risk because they provide a return on a regular basis. Theses assets are generally considered to be less risky than similar investments that also carry debt.
For instance, in the example of the investment property above, it would have a higher risk attached if it carried a mortgage. This is because the property would provide a lower level of income after accounting for interest payments. Any increase in interest rates would also reduce the property’s return over time, adding to its risk.
“Investing in income producing assets is more a tactic than a strategy,” says Borg.
“But providing this tactic is in line with your fund’s investment strategy then it has the potential to contribute to your SMSF’s overall goal,” he adds.
Considerations for retirees
So what should trustees be thinking about when it comes to income when fund members hit retirement?
Most importantly, in retirement fund members will need regular income.
“This can be achieved by having an increased level of liquidity or by choosing investments that pay a higher level of income,” says Borg, who says the right solution will depend on the fund members’ circumstances.
His advice to trustees is to structure their portfolio around their tolerance to risk and how happy they are to lose money as well as how much income they will need in retirement.
Says Borg: “Only once you know your position on risk and income can you structure a portfolio. It’s important to remember that having your money invested in income-producing assets does not preclude you from suffering capital losses.”
Doing thorough research can help trustees to understand how different income-producing investments are likely to behave through market cycles.
Missed the last "Investing for Income" Series article?
Last time, we explored the fundamentals of income-focused investing and how you can diversify your fixed income and cash investments in 2017.