If you have a defined contribution pension and have chosen to drawdown from it in retirement as opposed to the alternative options then one decision you need to look at is growth vs income funds.
Unlike defined benefit pensions, defined contribution pensions have no guarantee of income. Your pension funds remain invested and it’s up to you how much you withdraw each month in retirement.
This is why your investment strategy is key, take too much out too soon along with getting your investment strategy wrong can mean running out of money in retirement.
Growth vs income funds – what’s the difference?
There are two schools of thought when it comes to what is the right investment strategy for retirement.
On one side there is those that believe you should protect the starting value of your pension as you retire (your capital).
You invest into assets or investment funds that will produce an income and you then live off of that income.
If you invest into an equity (stock market) based fund the income will come from the individual companies within the fund declaring dividends. Other sources of income from other types of funds could include rental income from commercial property funds and fixed interest from bond funds.
On the other side there is a belief that you should focus on trying to grow the value of your initial capital and then sell down some of that capital each year to provide you with the income you need.
This can be achieved by investing in growth funds whereby the underlying companies tend to be younger and more focussed on increasing their profits. They don’t tend to pay dividends and instead try to increase their share price over time.
Growth vs income funds – which is best?
To decide which is the best investment strategy for your retirement will depend on what you would like to achieve, the lifestyle you want and how much time you want to commit to managing your pension.
In theory it sounds great that you could leave your capital untouched and just live off the income but in reality it will depend on how much income your investments produce.
Dividend yields from income funds tend to be around 3% – 4% so if you have a £200,000 pension pot is £6,000 – £8,000 per year enough for you? Don’t forget you will probably need to deduct Income Tax from these figures.
Of course even generating 3% – 4% income from your investments each year assumes you have picked good income funds and that they will continue to perform that way which rarely happens.
To generate the bigger dividends it usually means the underlying companies are bigger and more established. Think banks, insurance and energy companies. They have conquered their market and there is little room for growth so they just pay out the profits to shareholders.
Being big and dominant can make you lazy though and hard to adapt if sectors change and there is mass disruption.
Also, if your capital stays the same you are not combating inflation. A £200,000 pension pot is not going to be worth as much in 30 year’s time.
You need to decide whether you are keen to leave something behind for your loved ones. If you would like to leave the original capital behind and you feel you have a shortened life expectancy then income funds could be the way to go.
Your income will not be consistent though. Dividends change from year to year depending on the underlying companies’ profits. So some years you may find yourself short and then have to dip into your capital anyway.
Also, what happens if in one particular year or a short period of your life you want to spend more enjoying yourself? This again could mean you have to dip into capital again.
The alternative strategy of investing in growth funds spreads your risk a little more as some companies within a growth strategy will still pay dividends. By investing in accumulation funds your pension will re-invest the dividends and buy more units in the funds.
On average the stock market is generating positive returns 75% of the time but there will be periods of major declines and you may have to sell more units to generate the income you need.
If you want more flexibility in the amount of income you want (e.g. spending more now and less when you are older) then growth funds could be the way to go. You will eat into capital during the early years but then hopefully you will see growth in the later years to re-build your capital.
As what is often the case a mix of both strategies is probably best. What’s more important is that you:
- Are clear on your objectives.
- Understand the risk you are prepared to take with your investments.
- That your investment portfolio is aligned to your objectives and risk appetite.
Don’t just pick growth or income funds because you have read one is better than the other (I’m looking at you Daily Mail!). What matters is what’s right for you.
If you are considering retiring and are not sure on what to do with your pensions then please get in touch for a free no obligation 15-minute call. We would be happy to review your position, explain where you stand and what you need to do to get the retirement you desire. We’ve created hundreds of happy retirements, this could be you too!
Stock market linked investments and any income from them, can fall as well as rise and is not guaranteed. Any figures quoted are for illustrative purposes and should not be taken as a forecast or guarantee. Past performance should not be seen as an indication of future returns and clients may get back less than they have invested.