Truth behind income producing

Posted on: 27 April 2009 by Gareth Hargreaves

I have read about a plan that offers 4.95% income for three years and capital returned at the end. Is this a good plan?

The structured contract you are referring to is easy to be mixed up with a straight forward cash investment that offers true income such as a building society. They are often marketed as 'income producing' and to investors who are seeking an income, but the reality of what they provide is somewhat different.

To simplify, income in its truest form is provided by cash, property or fixed interests, or via dividends from shares. It is not reliant on capital growth and is provided irrespective of that.
Some investors rely on this as the best way to provide income, whilst others invest for growth and take what 'income' they need from the capital growth each year.

The plan above seeks to provide 4.95% per year for three years but there is a caveat. The caveat is that both the UK government and Morgan Stanley must remain solvent over that period of time. Furthermore the FTSE 100 must not be 50% or lower at the end of that three year period than at the launch date. Whilst I am sure this is already way beyond the simplicity a straight forward cash investor would normally expect the complications become much greater.

Firstly 4.95% return is only favourable in light of the extreme conditions we are enduring. If Mr Darling is correct and we return to growth by the end of the year, interest rates and quantitative easing will relax and 4.95% will no longer look as pretty as rates rise. If quantitative easing is indeed successful and inflation returns, interest rates will be the first port of call to slow growth. So in short, taking risk with your capital to receive such a paltry return is hardly worth while.

So what is the risk? The UK government not being solvent at the end? Possible but unlikely but the very thought is Armageddon like, and space prohibits the debate needed. Morgan Stanley becoming solvent? Let's remember this bank had to take a $5 billion cash injection from the Chinese government at the end of 2007 after a fourth quarter loss of $3.56 billion. Its situation was well documented.

The risk however falls back into the fact that this plan is a three year contract. Whilst we always tell investors not to invest for less than five years, here we have a plan that is offering an 'income' based on a performance over less than five years and that’s just totally unacceptable.

At my last check, the Newcastle building society was offering just over 4% for a three year investment. Investors could consider this but simply take the income they need today out of the capital they have, and set it aside to use over the period.

Patience will also be a virtue as the current situation relaxes so I shouldn’t be too hasty to lock into any contract such as this. Perhaps for the time being it may be better to consider a one year bond to access the best terms.

By then we should be much clearer on the benefit that quantitative easing and lower interest rates have had on the UK economy. Changes made to fiscal policy such as taxation, rate changes etc normally take eighteen months to make their way through, so in one year from now we should be pretty clear where we stand.

For the investor, be careful of much of these headline rates. Clearly some customers somewhere must be falling for them otherwise they wouldn't be coming up with such products every week. Not a day goes by that I don’t see a new shop window offering these arrangements, but in the last twenty years I have seen less than ten I would consider using, so take from that what you may.

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