Looking for income from investment trusts

What you’ll learn:

• How investment trusts can potentially provide a steady income.
• What the risks are.
• How dividends are taxed.

When it comes to investing for income, many investors choose a fund that invests in dividend-paying companies.

This can help reduce the volatility and risk of losses that can come with investing in just individual shares.

Unit trusts or open-ended investment companies (OEICs) typically contain a very broad spread of shares. These funds are open-ended, which means that there aren't any restrictions on the number of units or shares that can be issued. When new buyers come into the fund, the fund manager simply creates more units to meet that demand.

However, these aren’t your only options. Investment trusts, another type of collective investment scheme have a number of advantages. The main difference between these and unit trusts and OEICs is that they're closed-ended, so there's a limited number of shares in existence.

Here, we examine the benefits and risks of holding investment trusts for income.

Income and investment trusts

While open-ended funds pass on all the dividend income they receive from the companies they invest in, investment trusts don’t have to.

Instead, they’re allowed to keep some of the dividends that they earn back, to supplement income payments to shareholders in years when there might be a shortfall.

This can be potentially valuable to investors because dividend payments from companies will rise and fall – and are sometimes even cancelled altogether if a firm finds itself in financial trouble.

In a good year for dividends, investment trusts can keep up to 15% of their annual income, so that during tougher times, they can draw down on their reserves to maintain or increase their own payments to investors.

This lets investment trusts deliver consistent income payments. The payouts made by open-ended funds, by contrast, will automatically rise and fall in line with the dividends they earn on their investments.

Consistent increases in dividends

The ability of investment trusts to hold back income payments in good times has allowed some to build up a very strong track record of consistently increasing dividends.

The Association of Investment Companies (AIC), the trade body to which many investment trusts belong, maintains a record of trusts that have raised their dividends every year for an extended period – even during crises such as the dotcom collapse in the early 2000s and the credit crunch in 2008.

The AIC’s last review showed that there were 20 trusts that had increased their dividends every year for the past 20 years at least. Three funds in particular, City of London, Bankers, and Alliance, have managed to raise their dividends every year for the past 52 consecutive years.¹

But while many trusts have been able to raise dividends consistently in the past, there are no guarantees they’ll be able to continue doing so in the future. Their past performance is not a reliable indicator of their future performance. Always remember that the value of your investments can fall as well as rise and you could get back less than you invest.

The drawbacks to dividend smoothing and investment trusts

Against all this, investors should recognise there will be years in which open-ended funds offer more income than investment trusts, since they’re passing on everything they earn.

What’s more, investment trusts’ reserve funds only provide a certain amount of protection. Once they’re exhausted, trusts have to cut dividends too. However, if shareholders approve, they’re able to pay income out of their capital profits – for example, by selling some shares.

But while the rules applying to investment trusts can be beneficial for income seekers, there are several risks to consider. As previously mentioned, the main difference between investment trusts and open-ended funds is that they are stock market listed and therefore closed-ended. In other words, there are a limited number of shares in existence, so if you want to invest after a trust’s launch, you can only do so if another investor wants to sell their shares. In contrast, when investors want to buy into a unit trust or OEIC, the manager makes it possible by creating new units and then invests this new money.

Market demand also dictates an investment trust's share price, which can move either above or below the value of the assets that it holds – called the Net Asset Value (NAV). With open-ended investments, your holding will rise and fall in value with the movement of the fund's underlying assets.

If an investment trust’s share price moves below its NAV, it's said to be trading at a discount. If it rises above, it's trading at a premium. Investors often seek out trusts on a discount because it means they can pick up the shares at a cheaper price. For example, if a trust is trading at a 10% discount, you can get an interest in investments that represents £100 worth of shares for £90. In addition, from an income perspective, you'll continue to receive dividend income derived from £100 worth of assets.

However, if you invest when a trust is trading at a premium, you’ll be paying over the odds. If a trust boasts a high yield and/or a decent income track record, don’t be surprised to find it trading at a premium, as these trusts tend to be very popular.

Find out more about how investment trusts work

How dividends are taxed

If you’re investing for income, it’s important to think about the tax treatment of any dividends you receive, whether from open-ended funds or investment trusts.

Under current dividend allowance rules, taxpayers can receive up to £2,000 in dividend income each year without paying any tax at all. Above this threshold, basic-rate taxpayers must pay 7.5% income tax on the excess, while higher-rate and additional-rate taxpayers have to pay 32.5% and 38.1% respectively. When income-producing investments are kept in an ISA, there’s no tax on dividends.

You can find out more on how dividends are taxed on the government’s website. However, we don’t offer tax advice so if you’re not sure about the tax implications and feel you need help, it’s worth seeking independent advice.

Remember that tax rules might change in future and their effects on you depend on your individual circumstances, which can also change.