How to make your savings pay

Prepared to take risks? Then stocks and shares can yield big dividends

The Bank of England cut interest rates for the sixth month in a row this week, taking the official bank rate to all-time lows of just 0.5 per cent. Although this has been great news for anyone with a tracker mortgage, it's been crippling for savers, who have seen the interest on their accounts dwindle to next to nothing since last autumn. The average savings account is now paying well below 1 per cent, while even the best on the market are offering not much more than 3 per cent.

For those who are saving for the longer run, even savings rates of 1 or 2 per cent represent a decent return on your money after tax and inflation has been taken into account. Six months ago, when inflation was pushing 5 per cent, you needed to be earning more than 6 per cent to achieve a return that kept pace with the cost of living after tax had been deducted. But with inflation now at 0.1 per cent, even 0.5 per cent will leave you with a net real return.

However, for people who have been relying on their savings to generate an income, this is no consolation. Someone with £50,000 in the bank could have been earning a gross income of over £200 a month a year ago. Today, they'll struggle to get half as much from a cash savings account – and will be forced to start drawing down on their capital if they need to maintain their income at the same level.

As a result, more and more people are looking elsewhere for a decent return, with stocks and shares now beginning to emerge as a new favourite for income seekers.

Rising yields

Although investors may have been shaken by the stock market falls of the last week – which saw the FTSE 100 index dive close to its March 2003 lows – the latest dip has helped push up yields on equities to ever more attractive levels. Nevertheless, such high levels of volatility, combined with the ongoing economic uncertainty, mean it's more important to be careful when picking stocks for income. Banks, for example, may be registering prospective double-digit yields, but it's unlikely that these will ever be paid.

However, Robin Geffen, who manages the Neptune Income fund, says that there are a number of quality blue-chip companies which are now offering good yields – and should not pose too much of a risk to your capital if you're taking a medium- to long-term view.

"People are going to continue eating, smoking and using power," says Geffen. "And there are some big quality blue-chips in these areas which offer certainty for investors, and are yielding 4 or 5 per cent."

He cites the likes of AstraZeneca, GlaxoSmithKline, Imperial Tobacco, National Grid and Unilever as a sample of big businesses which his fund has been investing in. "On a three- to five-year view, which is the minimum that investors should be taking, I don't think there's a significant risk to capital in these companies," he adds.

Although some companies are offering dividends of 10 per cent or more, Geffen adds that investors should see this as a warning sign, as these levels of payouts are unlikely to be sustainable. In particular, he says investors should remain wary of the banks, insurance companies and property groups.

Remember that there are never any one-way bets on the stock market – not even the big companies are immune from dividend cuts. Big US firms such as General Electric and the pharmaceuticals giant Pfizer have made cuts to their dividends in recent weeks, which is why you should invest in a number of companies.

Pick a professional

The best, and perhaps the safest, way to do this is to buy an equity income fund, which is managed by a professional fund manager. Do some research before you decide which fund to go for, as some of them are riskier than others. Geffen's Neptune Income fund, for example, is currently yielding around 5.5 per cent, and sits at the lower-risk end of the spectrum. However, there are funds in the same sector yielding as much as 10 per cent – a level which is likely to be unsustainable.

According to Brian Dennehy of the London-based financial advisers Dennehy Weller, around a third of equity income funds have cut their payouts over the last month. Those funds which invested in banks last year have been particularly hard hit.

However, he says there are a number of quality managers who will be able to maintain their current dividend. He picks out the Newton Higher Income fund, managed by Tineke Frikee, which is yielding around 6.5 per cent, and which has been one of the top 10 performers in its sector over the past year. He also likes Standard Life Investments' UK Equity High Income fund, which is yielding around 5.5 per cent. Its largest holdings include Vodafone, Glaxo and British American Tobacco – some of Britain's biggest corporations.

Alternatively, you could consider managers such as Neil Woodford at Invesco Perpetual, who continues to have one of the most impressive records in the equity income world. Over one and three years, his two funds are amongst the top five performers in the UK equity income sector, while over five years, his funds are number one and two.

If you're nervous about making the switch from cash to equities, Dennehy says that you don't need to invest all your cash at once. "If you've got £10,000, for example, then my advice would be to split it into 12 lumps and to drip it into the market over the next year. People forget that if they've got a lump sum, they don't need to invest it all at once."

Unless you're an experienced investor, you should take professional advice before you invest your money. To find an independent financial adviser in your area, visit www. unbiased.co.uk.

If you don't like the idea of investing in the stock market, you could consider a bond fund – which invests in the debt of companies, governments or both. However, as with investing in equity income funds, there's a wide spread of risk amongst the funds on the market, so you should be careful where you put your money.

Again, you can pick up yields of between 2.5 and 10 per cent in corporate bond funds. But the higher the yield, the higher the risk tends to be. Mark Dampier, the head of research at Hargreaves Lansdown, the Bristol-based financial advisers, says very cautious investors should look into M&G's Corporate Bond fund, Jupiter's Corporate Bond fund, or Fidelity's Moneybuilder. These all yield around 5 per cent.

Although Dampier believes there is great potential in the bond market at the moment, he warns that, like equity income funds, these are not without risk. However, he suggests that investors who are nervous about investment risk should split their money and invest a proportion that they are prepared to take some risk with into equity income or bond funds, and leaving the rest in cash.

To find the best cash savings account rates, see our best buy tables on page 64, or visit www.moneyfacts.co.uk.