What purpose does the Income Fund serve?
by George Hatjoullis
The Income Fund is a popular but somewhat puzzling financial product. If you own it in a drawdown pension plan all withdrawals are taxed as income. If you own it within an ISA there is no tax on withdrawal. If you just own it, the dividends are taxed as income and any price growth as capital gain (if and when you realise). Given that capital gains tax rates are often lower than marginal income tax rates, and there is normally a CGT allowance, why seek income? If a fund grows by 5% per annum, but accrues no dividends, one can take 5% income by selling an appropriate number of units. It either has no, or advantageous, tax implications. Logically, investors should typically be concerned with total return, irrespective of source. The existence of Income Funds as a product class suggests this is not the case.
One problem with total return is that funds do not grow smoothly. If an investor wants a regular income (say in retirement) for an unspecified (but finite) time, then it is hard to judge how much to take as income. The key question implicit in this dilemma is what level of income is sustainable? The role of the Income Fund is to provide the investor with a sustainable, and preferably growing, income. The income should at least grow in line with inflation. The Income Fund manager is thus concerned with growth in distributable earnings and distribution (or dividend) policy.
The earnings growth of a portfolio of assets is significantly dependent on macro factors. This is the whole point of holding a diversified portfolio. It is possible, in principle, to identify the impact of macro factors on earnings growth. If for example GDP growth is found to ‘explain’ a significant portion of earnings growth it provides a reference for judging sustainable earnings growth. If earnings is growing faster than GDP it may signal unsustainable growth. If companies then payout these unsustainable earnings as dividends, the Income Fund manager might consider not paying out all the dividends and reserving some for later leaner years. The Income Fund could thus offer a smoothed income that grows in line with inflation (at least) and can be expected to be paid in perpetuity.
Payout or dividend policies are quite variable across companies and can change. They may or may not correlate to some notion of sustainability on an individual company basis. It thus makes sense for an Income Fund manager to form a portfolio view of sustainability and offer this view through the Fund payout policy as part of the financial product. A portfolio is simply a proxy for the private sector of an economy and the two are inevitable linked. Of course, fiscal policy,tax, interest rates, credit spreads, currencies, inflation rates, commodity prices and so one, will also impact earnings and sustainability. The potential set of macro factors is large, but at any point in time a subset will explain most variation in earnings and offer the Fund manager a reference for sustainability.
In answer to the question I posed in the title, one possible purpose of an Income Fund is to provide investors with a sustainable and growing income. It is hard for individual investors to judge what is sustainable. Moreover, sustainability is best referenced with respect to a continuously updated set of macro factors, and fund payouts smoothed to match the estimated sustainable income. There is a potentially large investor base that would appreciate access to such funds through income drawdown and ISAs.