Annuities are not the only fruit

People whose investment income has been whittled away by low interest rates may decide it's time to Split. By Chris Whittington

Falling mortgage rates and rising house prices have led to claims that the "feel-good factor" has returned.

However, for those who rely on deposit accounts for a substantial part of their income, good feelings are becoming a thing of the past. Banks and building societies have recently been steadily reducing the interest rates paid to savers.

Increasingly, investors have been forced to evaluate alternatives to leaving money on deposit. One solution is to purchase an annuity; this option is taken up by many retired people despite the complete loss of capital which these products inevitably entail. For most people an annuity should be regarded as a last resort, as most will wish to leave some capital to future generations or to good causes rather than lose it all to the annuity provider. So what are the alternatives?

Despite their forbidding-sounding title, income shares of split-capital investment trusts are an excellent alternative. A split-capital investment trust is one with more than one class of share capital. Splits, as they are known, aim to meet the need for both income and capital growth. Typically, there will be two share classes, one of which takes all of the income from the underlying pool of investments and another which aims purely for capital growth.

Because income shares are entitled to all, or at least the lion's share, of the income earned by the trust, they offer high yields, often well in excess of 10 per cent. Moreover, the underlying portfolios are frequently invested in equity shares, so income shares can be expected to grow their dividends over time.

So what is the catch? After all, an 11 per cent yield with the chance of growth in income looks too good to be true. The drawback - although it's not a drawback relative to annuities - is that in some cases income shares are excluded from the growth in capital achieved by the investment trust.

All of the growth in capital is often received by other classes of shares in return for their forgoing the income generated on their assets. In some cases, when a split-capital investment trust reaches the end of its life, the final value of an income share may be lower than that paid by the investor.

In other cases, the income share entitlement at wind-up is not fixed and will vary depending upon market conditions and the degree to which the trust's manager is successful in growing its assets during its life. With split-capital investment trust shares having been out of favour with investors over the past couple of years, the valuation of income shares now stands at such a low level that a number may well provide capital growth over the balance of their lives.

The problem for most investors is how to choose between the wide range of income shares available. Which income shares have the best chance of holding their current value or increasing it? In recent years, a few fund management firms have sought to provide a "user-friendly" route to investment in income via unit trusts which invest entirely or mainly in them.

A professional fund manager is able to take advantage of the inefficiencies of the market in income shares in order to build up a portfolio at prices not often available to the investor.

Unit trusts based on income shares can be tax-efficient choices for inclusion within a PEP. Most equity unit trust PEPs yield only around 4 per cent, so that a unit trust invested mainly in income shares yielding more than 10 per cent should save around two-and-a-half times as much in income tax in any given year. If pounds 6,000 per annum were invested in a PEP over a 10- year period at a yield of 10 per cent, this would provide a total tax-free income of pounds 6,000.

Given the limited prospect for capital growth from an income share portfolio there is unlikely to be a saving of capital growth tax, but it should be borne in mind that many investors never pay capital gains tax anyway.

For a list of income share providers and fact sheet, contact the Association of Investment Trust Companies (0171-431 5222).

The author is investment director at Exeter Fund Managers.