Savings & Investments

An annuity is a financial product whereby an individual provides an upfront capital amount in exchange for regular income payments for a specified period of time.

The rate of income that an individual is paid (the annuity rate) depends on various factors including their age and state of health, the capital amount, the length of the term, and current market rates as measured by the 10-year gilt yield (i.e. a UK government bond that matures in 10 years’ time).

The Purchasing Power of 10-Year Gilts and Annuities

Consider the purchasing power of a 10-year gilt: if you wanted to hold one of the most secure types of investment possible, what return could you have expected over time?

In 2008, before the global financial crisis, the yield on a 10-year gilt was 5.45%. You could receive an income of £5,450 a year on a £100,000 investment, so in terms of making a retirement decision and income planning, this was a relatively straightforward position to be in.

As interest rates were cut in the years that followed to stimulate the economy, so too did bond yields fall. By 2021, the 10-year gilt yield had moved down to 0.54%. An investment of £100,000 now provided about £500 a year of income – a fall of 91% compared with 2008 levels.

Thus, if you wanted to generate a secure income of about £5,000 a year, you now needed £1,009,259!

In recent years, the Bank of England has been raising interest rates to bring persistently high inflation under control. In response, 10-year gilt yields have also risen, to over 4% for 2023 – and almost back to 2008 levels. Thus, if you want to generate a secure of £5,450 a year today, you now only need £133,252.

Annuities have therefore become a viable retirement strategy once again, and are becoming a popular option for investors who want a dependable rate of return.

A variety of annuities are available, and additional features can be incorporated into annuity contracts based on your individual needs and circumstances. Should you wish to find out more information or discuss how an annuity would work for you, please get in touch with your Financial Advisor.

What is an Equity?

An equity is a share of ownership in a company. An investor who owns the shares (a shareholder) is therefore a part-owner of the company, and confers upon them a number of rights, depending on the type of share they own.

Ordinary shares are the most common form of shares issued by companies. Among other rights, shareholders have the right to share in the company’s profits in the form of a dividend. If the company makes larger-than-expected profits, ordinary shareholders can participate in a higher dividend.

Preference shares are the second most common form of shares. One characteristic is that they pay a fixed rate of dividend. While preference shareholders do not participate in higher dividends like ordinary shareholders can, preference shares are often seen as a less risky form of investment than ordinary shares.

Dividends on equities are not guaranteed, though, and can be cut, suspended or cancelled entirely.

Figure 1 shows that the trend in global dividends by geographic region, as measured by the Janus Henderson Global Dividend Index (a long-term study of global dividend trends), and whether companies on the whole are paying out a rising or falling amount to shareholders over time.

Janus Henderson Global Dividend Index (by geographic region)

Figure 1: Janus Henderson Global Dividend Index (by geographic region). Source: Janus Henderson. Used with permission.

Dividends are generated when companies pay out a proportion of their profits to shareholders as cash, and this generally rises over time as cash flows improve and profitability increases. Hence, profitability is one internal factor (i.e. a factor that is specific to a company) that influences dividend policy.

However, as well as internal factors, company dividend policies are also influenced by external ones that are outside of a company’s control, such as the general state of the economy. One example is the COVID-19 (coronavirus) pandemic, during which time many businesses closed and consumers were unable to go out and spend. Janus Henderson estimates that the pandemic caused global dividend cuts of $220 billion in 2020, as companies sought to shore up their balance sheets to weather the financial impacts of the crisis (or, in the case of banks, required to do so by their respective regulators). The extent of these cuts is represented by the falling line in Figure 1.

The UK and Europe were the most severely affected regions, and Australia in the Asia Pacific ex Japan region. Traditionally, Income portfolios have a natural bias towards the UK and Europe on the basis that these developed areas of the market have provided high and attractive dividend yields historically (Figure 2).

Global Dividend Yields

Figure 2: Global Dividend Yields. Source: JP Morgan; data as at 31 July 2023. Used with permission.

In contrast, Japan and North America were very resilient in 2020 (as shown by the orange and purple lines in Figure 1).

Japanese companies are known to have high levels of cash and low levels of debt on their balance sheets, which helped to support dividend distributions during the pandemic. Corporate governance reforms in Japan (as well as Asia more broadly) have led to noticeable improvements in shareholder-friendly practices over the years, such as dividend pay-outs. Further, companies in Japan are more effectively using their capital to generate profits and, subsequently, returns to shareholders (Figure 3).

% of Companies with Net Cash

Figure 3: % of Companies with Net Cash. Source: Trustnet; data as at 31 May 2022. Used with permission.

In the US, share buybacks are a common practice as they can be more tax-efficient for companies than paying a dividend. This involves a company buying back its own shares from investors and subsequently cancelling the repurchased stock; as there are fewer shares in circulation, shareholders’ stake in the company (and the amount they are due from future dividends) increases. US companies typically spend billions of dollars a year in share buybacks.

On the whole, dividends have been reinstated since the COVID falls, as shown by the general upwards-moving line since 2020. From a geographic perspective, according to Figure 2, UK and European companies continue to offer attractive dividend yields. As with any portfolio, though, diversification is a key strategy as this helps to build resilience in an unpredictable global environment.

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What is a Bond?

Bonds are debt instruments issued by governments and companies, as a way of raising money for new projects, business expansion, or other expenditures.

Bonds are typically issued with a maturity date, at which point an investor receives a fixed amount of capital (called the nominal value). For UK bonds, this amount is invariably £100 per bond – this means that if the bond is held to maturity, investors will receive £100, regardless of what the market thinks of the price in the meantime.

Between now and maturity, the bond pays interest at a specified rate, generally every six months. The rate of interest that a bond pays is meant to reflect the risk of these issuers. For example, UK government bonds (gilts) and US government bonds (Treasuries) are considered to be ‘risk-free’, as these governments are unlikely to default on their financial obligations, hence they tend to pay relatively low rates of interest.

The rate of interest on corporate bonds (i.e. bonds issued by companies) will typically be higher than government bonds as they come with more risk, given that a company is more likely to default on their payments than a government. That said, this depends on the issuers in question.

Although bonds can offer fairly reliable returns, issuers can default on their loans just like any other borrower. Generally, coupons on investment grade (high quality) bonds are more secure than on high yield bonds, and on government bonds versus corporate bonds (again, dependent on issuer).

As with all investments, bonds carry risk, and prices can go down as well as up. In particular, bonds are sensitive to inflation and interest rates, and expectations thereof, since most bonds pay a fixed rate of interest. If inflation is rising, central banks will likely increase interest rates, to encourage people to borrow less and save more – the theoretical reduction in demand for goods and services could then slow inflation.

Consequently, investors no longer prefer the lower rate paid by the bond, resulting in a decline in its price. The converse is true if inflation and interest rates are falling, or expected to fall. Some bonds are more sensitive than others in this regard.

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