A drastic solution is to buy an annuity - drastic because though you earn high income, you pay the heavy price of sacrificing all your capital when you die.
For people who want to leave an inheritance to their children or grandchildren this is not acceptable. So, more often than not, they hold on to the ownership of their capital by keeping it in the building society and put up with lower living standards.
But there is an alternative. It is to buy the "income shares" issued by a kind of investment trust known as a "split level trust". These take the lion's share of all dividends from the investment trust. Dividends are still on an upward trend, unlike interest rates. So they can provide a high income - around 11 per cent at the moment.
Of course, nothing is for nothing and the drawback with income shares is that they may exclude you from any capital growth in the underlying assets of the investment trusts. For someone seeking to build up capital, therefore, income shares are the wrong solution. But for the older person whose priority lies in the present and not in the future, the discreet charms of income shares deserve to be better known.
They can give you just as much income as an annuity without involving the sacrifice of all your capital. They enable you to have your income cake and eat it, too. And, as dividend income grows, you have the possibility of seeing your income grow, too. You won't get the sort of capital growth an equity income fund tends to produce, but you should retain a decent sum to hand on to your family.
And - again in contrast to an annuity - if you change your mind, there is nothing to stop you selling your income shares and either investing in something else or simply spending some of the money.
So how do you buy income shares? In the past the answer was: "With difficulty." For each "split level" investment trust has a fixed life, at the end of which it may be wound up and the money given back to the investors. The price of the shares depends to some extent on how many years of life the trust has left. This effectively made income shares too complicated for most individual investors of average means.
In recent years the problem has been solved by the emergence of unit trusts investing entirely or mainly in a portfolio of income shares. They have transformed income shares from being the preserve of wealthy individuals and financial institutions into an investment which the average person can now consider. By buying in bulk, the fund manager buys a portfolio of income shares at prices not obtainable by the small investor on his own. And he manages them to take account of any changes in market conditions.
Unit trusts based on income shares can also be held in a Personal Equity Plan, which adds tax advantages to the attractions of a high income. The average equity unit trust PEP yields 4 per cent or less, so a pounds l,000 investment would provide a dividend in the first year of pounds 40 - a tax saving of no more than pounds 10 for the average taxpayer and pounds 16 for the top rate taxpayer. By contrast, pounds 1,000 in a unit trust based on income shares and yielding 10 per cent saves you tax of between pounds 25 and pounds 40 a year inside a PEP.
If you invested your full PEP allowance of pounds 6,000 in an income share fund which yielded 10 per cent a year for 10 years, you could hope to have net income over that period of pounds 600 a year, or pounds 6,000 in all. On this the cumulative tax saving, on current rates of income tax, would be between pounds l,200 and pounds 2,400.
You will not be saving any capital gains tax because you won't be making much in the way of capital gains. But, since only a small minority of people ever pay capital gains tax anyway, that is hardly a drawback. On balance, then, unit trusts based on income shares merit investigation by savers who need maximum income right away from modest amounts of capital.
A list of income share providers and a fact sheet is available from the Association of Investment Trust Companies (0171-431 5222).
The writer is investment director of Exeter Fund Managers (01392 412144).Reuse content