Taking risks with savings can magnify your returns

Leaving cash languishing in low-paying savings accounts is no longer sensible, but there are alternatives for those who rely on the income they get from their nest egg

Retired journalist Graham Andrews is among thousands of people who have turned their backs on high street banks and building societies in favour of seeking a regular income from supposedly riskier investments.

"The returns were so appalling on the high street that I only keep a bit of rainy-day money in them now," he says. "Most of my money is now in a combination of stocks and shares, Individual Savings Accounts (ISAs) and a few selected unit trusts."

The 67-year-old, who lives in North Devon, used the discount broker Willis Owen to put together a portfolio of funds, which includes Schroder Monthly High Income, Newton Global High Yield, Old Mutual Dynamic Bond and Invesco Perpetual Distribution.

"I wanted income on a monthly basis to supplement both my company and state pensions, so picked funds yielding between 5 and 9 per cent, which is not a bad return," he says. "Having ISAs means the income is also shielded from the tax man."

How to generate a regular source of income is not only becoming an issue for older people living off their savings, but also an increasing number of families that rely on investments to help pay regular expenses, as well as luxuries such as holidays.

The rock-bottom interest rates have made it increasingly difficult to earn decent levels of income from traditional sources such as banks and building societies. However, these institutions should not be completely ignored, argues Justin Modray, founder of the financial website CandidMoney.com. Everyone should have some money set aside that can be easily accessed without many restrictions.

"If you are a nervous investor then a high interest savings account looks attractive now," he says. "Cash is still the poor relation but you can earn 3 per cent by shopping around and up to 5 per cent in exchange for locking your money away."

The accounts are generally straightforward to open, simple to understand, and money can be deposited quickly and easily. The downside is that the income generated depends on prevailing interest rates, which are subject to change.

For those with more money to invest, two of the main assets that produce income, according to Geoff Penrice, a financial adviser with Honister Partners, are dividends from shares and interest from fixed-interest products, Although the amount of income generated will vary depending on the product, the estimate figures for the different asset classes are 5 to 7 per cent for fixed interest, and up to 4.5 per cent for equity income, as well as the potential for capital growth, Penrice suggests.

"The problem is that these assets come with a degree of volatility and investment risk," Penrice adds. "Which one is most suitable will depend on their objectives, and whether generating an immediate income is required."

Establishing their attitude to risk should also go hand-in-hand with an investor's objectives, says Andy Gadd, head of research at Lighthouse Group. The key consideration is how much of a risk do they want to take with their money.

"They also need to decide for how long they want to invest," he says. "The credit crunch may have dented investor confidence but there is still value to be found in bonds, property, or equity income."

Bonds

Fixed-interest products, known as bonds, involve an investor effectively loaning money to a government or company in exchange for a fixed rate of interest over a pre-determined period, along with the bond's face value returned on a specified future date.

With corporate bonds, although there is no guarantee that the issuing company will keep up with the interest payments – or pay the face value on the date of maturity – the likelihood of them honouring their commitments is analysed by ratings agencies.

These specialists give each company a rating based on their assessment of its ability to pay back its debts. The most trusted will be awarded AAA status, and then it goes down on a sliding scale.

Therefore investors will be putting their faith in riskier companies in exchange for a higher level of income.

Most retail investors that want bond exposure will choose to access them via a pooled investment, such as a unit trust, run by a specialist manager.

Equities

Even riskier investments are equities, where you can either buy into companies that are expected to pay decent income to investors in the form of regular dividends, or opt for an equity income fund and let a manager take the strain.

According to Alan Easter, the director of brokers Willis Owen, a popular option within this area is the Invesco Perpetual Income fund.

"Under its manager, Neil Woodford, this fund has served investors extremely well over the long term and his defensive approach should bode well over the next couple of years," Easter says. "Another option is the Artemis Strategic Bond, which has generally achieved reasonable returns with a relatively low level of volatility; a key factor for income-seeking investors."

Then there are commercial property funds, points out Andy Gadd. "The yields achievable on these depend on factors such as the real interest rate, rental expectations, and demand for space," he says.

So which looks the most attractive? There are pros and cons with each of the income-generating asset classes, so a hybrid product could be the best fit, suggests Darius McDermott, managing director of Chelsea Financial Services.

"I like the Schroder Income Maximiser, which has paid out an annual income of at least 7 per cent since its launch four years ago," he says. "It has taken the top performing Schroder Income fund and enhanced it with derivative underwriting."

This equity-based fund works by investing in a portfolio of generally high-yielding stocks whose share prices appear low relative to their long-term profit potential. The income is then topped up by the writing covered calls, which effectively sees the company selling some future upside potential.

You can even consider looking overseas for income, adds McDermott. "People are looking globally because the UK market gets most of its dividends from about 10 companies," he says. "However, investors need to acknowledge that such a strategy comes with associated potential dangers, such as currency risk."

Instead of restricting yourself to a particular income-generating asset, it might be an idea to hold a few different assets within your overall investment portfolio, suggests Gadd.

"It is ultimately sensible to have a diversified portfolio with elements in cash, fixed interest, property, and equity income funds," he says. "The allocations to each will depend on the risk profile, aims, and objectives of individuals."

Investors should also make sure they are being tax efficient – so that means making the most of their annual Individual Savings Account (ISA) allowance, according to Rebecca O'Keeffe, head of investment at Interactive Investor.

"With over 100 funds paying yields of 5 per cent or more, it makes perfect sense to minimise the tax you pay on this income," she says. "In fact, if investors hold income funds outside an ISA but growth funds inside, they should give serious consideration to switching their allocation."

Whichever income-generating route you choose, it is important not to rush in and buy the first fund that catches your eye, advises Graham Andrews. "Do some homework and then, hopefully, you can sit back and enjoy the income," he says. "If you are lucky enough to get some capital growth as well then you can think of it as a bonus."

Income strategy: A global view

Searching for income has been one of the strategies successfully adopted by Tom Orchard, pictured, in recent years. He favours taking a more global outlook when it comes to choosing investments.

The 48-year-old has invested in Murray International, a global equity income investment trust, and the Aberdeen Asian Income fund, which puts its money in a range of Asian Pacific securities. "I receive a dividend four times a year from Murray International, which I invested in because it has a good track record," he says.

Mr Orchard has also been keen to get some Asian exposure because he sees this region as a key beneficiary of future growth. "Investing in global funds means you are not relying on Britain, whose prospects do not seem very good, and Asia seems to be where everything is happening at the moment," he explains.

He also makes regular deposits. "I would advise investing on a monthly basis rather than putting in a large lump sum because you can never get the timing right."