A report from the recently published Capita UK Dividend Monitor showed that 76% of dividend payments in the first quarter of 2014 were concentrated in just five of the top stocks in the FTSE 100 and that the oil and gas sector, the second largest provider of dividend income after financials has dropped payouts by 7.3% in the same period. Alongside this, additional reports that a number of funds in the IMA UK Equity Income sector are failing to meet the required income threshold might well see advisers looking for alternative means to achieve income for their clients, not least as a means to diversify the risk in portfolios.
The defined nature of structured products, in that the payout, time frame and market conditions to achieve the set returns are known in advance, offers an alternative to traditional income generating investments for clients looking for above-cash, above-inflation returns.
The flexible nature of structured products means that, given the right pricing scenario, there are numerous ways in which to structure investment and deposit plans to deliver income.
Taking four of the recent structured income offerings, they provide for annual, quarterly and monthly income payments all based on the performance of the FTSE 100 index. The rate of return is based on the different structures involved, which, assuming that the Counterparties / Deposit Takers of the investments remain solvent throughout the term, simply are:
Investment 1. Income is paid regardless of the index performance with capital returned in full unless the index has fallen more than 50% from the initial index (strike) level during the term.
Investment 2. Income is paid as long as the index is above 90% of the strike level, with full capital return and deposit-based FSCS cover.
Investment 3. Income is paid as long as the FTSE 100 is no more than 15% below the strike level at the quarterly observation point and capital is returned at maturity if the index is no more than 40% below the strike level.
Investment 4. Income is paid as long as the FTSE 100 is no more than 20% below the strike level at the quarterly observation point and capital is returned at maturity if the index is no more than 35% below the strike level.
As can be seen, within just these four products, there is a range of options depending upon the client’s attitude to risk. Gross annual payments for these products range from 4.4% to 6.5%, depending on the structure and the level of risk involved. What has to be noted is that with three of the four, if the index is below the stipulated level then no income is generated for that period. With one of these three however, there is a memory feature built in which means the first subsequent income payment will comprise the pre-defined interest payment for that income period, plus the total of all rolled-over income payments that had not been paid.
The fact that income is dependent on the performance of the index means use of such contracts needs to be considered very carefully, balancing the client’s overall attitude to risk and willingness to trade potentially higher reward for the greater risk of not achieving income needs in some years.
However, a complimentary strategy that works well for investors seeking income is to utilise other investments that take advantage of the client’s capital gains tax exemptions to offset the gain made and provide a source of capital from which the investor can supplement their income needs. For example, structuring a mini portfolio of growth investments that are then used to provide a regular or ad-hoc payment can be a much more tax efficient approach.
Aside from the usual collective investment suspects, one such example is autocall contracts. These have, in general, a 5-6 year term but can mature early on a set anniversary if the index is higher than the strike level. Current payouts range from 5% to 12% for each year held, with potential for maturity from year one onwards. Using these products therefore takes a degree of forward planning by the adviser but can be useful additions to a portfolio.
Whether using structured income products or growth investments or a blend of the two, it should be possible for advisers to deliver a viable income stream for clients as part of balanced and diversified investment strategies.
