Morning all! I’m off to stay with some old friends in the Balearics for a few days, and I’ve no intention of keeping up with the Spanish until 4am and then rising to write a post for you at daybreak.

Come now, don’t be like that – it’s not easy doing this every Saturday for five years you know.

Okay, okay, here’s a few links I prepared earlier that I think you’ll find interesting.

Enjoy!

• The Eurozone crisis – A bulletin board post from a poster I hugely respect
• US unemployment truly awful [graphic] – Worse slump for generations
• Oaktree Capital Memos – Buffett’s faves, start at the top and work down
• Asset class correlations – It’s all bunk
• My barber is a millionaire – Darwin’s Money
• Stretching rubber band creates more value – Investing Caffeine
• Spending strategies in retirement – Oblivious Investor
• War is a racket – A bit old this one (from 1881!)
• Vanilla Ice real estate – Sadly not a joke

Like links? Subscribe to get them every Saturday. (Even when I’m on holiday!)

I often read comments from private investors – or even in magazines and newspapers – suggesting that to live off investment income you should choose your holdings according to when the income is paid.

According to this theory, a high yield portfolio ought to have some shares that pay dividends in January, some in February, some March, and so on, to spread the income over the year to meet your monthly spending needs.

The same holds – they say – for other sorts of investments. Most income trusts pay their dividends quarterly or twice a year, so the investor is urged to pick their trusts accordingly. Or you’ll hear buy-to-let property being touted specifically because the inflow of cash from rent will arrive on a monthly basis.

But this is a crazy way to live off investment income.

Firstly, you should not be relying on such income to arrive on a monthly basis like a salary. It’s too precarious. Rent can be skipped, dividends cut, and the interest on cash slashed.

Secondly, you shouldn’t be spending all your money every month anyway, hoping you can make it to the next dividend. There are many reasons to live off investment income, but a stressful life is not one of them.

Thirdly, you cannot afford to add the spurious requirement of ‘When will I get paid?’ to your selection process when designing your income portfolio. You need to focus on asset allocation, diversification, and other more important factors.

You may even want to own some assets that don’t produce an income at all, but will either need to be periodically sold down (for instance a gold ETF) or else that mature as a lump sum (such as an NS&I index-linked bond).

Finally, I’d urge people pursuing lifetime financial freedom to continue reinvesting some of their investment income after quitting work, at least early on. Again, monthly get-and-spend thinking works against that.

A better way to live off investment income

You need to decouple your income streams from your outgoings, in a methodical and modifiable way:

1. Set up a cash buffer account between your regular monthly spending, and your income-spewing engines.

2. Work out how much of your annual investment income you will/can spend. The rest of the money you will reinvest.

3. Load your buffer account with a very healthy float of money.

4. Direct all your investment income to be paid into the cash buffer account (by a proxy current account if need be) and set up a monthly direct debit out of the buffer and into your spending account. The monthly debit from the buffer is your permitted annual spending amount from step #1, divided by 12. This is the money you can spend each month!

5. Finally, as your buffer grows (because you’re taking less money out than you’re paying in) you occasionally reinvest the surplus back into your income investments.

Now, compared to spending your dividends and your other income the moment it arrives, this system does mean you’ll require a bigger investment pot – or else you’ll need to live on less money than you’d hoped. The cash buffer will gobble up a chunk of your funds, and the safety margin you’ll be reinvesting also cuts your monthly spending.

But the reward is a rock solid monthly income, infinitely greater piece of mind, and a portfolio chosen entirely on its merits that can easily be modified to accommodate lumpy investments such as maturing bonds or capital growth products, as well as non-investment income such as gifts from older family members, or piecemeal part-time work.

Tips on setting up your income pipeline

I have previously written about creating an income portfolio to replace your salary, so please do read that article for more on building your income portfolio.

Also, I am ignoring tax, since everyone’s circumstances vary. Needless to say, you should set up your income system in a tax-efficient way, using ISAs, SIPPS, and your annual capital gains allowance.

Here are a few other tips on designing your income regulator:

Keep at least a year’s spending in your cash buffer

I suggest you hold at least 12 months total spending in this buffer, and preferably more. That might seem incredibly tough, but in the mid-1970s and again in 2008 dividend income dived in real terms. Also, rent can go AWOL, interest on cash can be cut, and formerly rock solid vehicles like PIBS suspended. If you’re living off investment income, you need a safety net.

The cash buffer should be in multiple high interest accounts

Conceptually, it’s one ‘float’ of cash, but for insurance purposes you should spread your money between two or more banks. Take into account the maximum compensation per bank from the FSCS guarantee scheme (currently £85,000) but spread your money anyway – if one bank melts down you will still need to eat while you await your compensation. You may also need to employ multiple accounts to be permitted sufficient annual withdrawals at a decent interest rate.

The buffer should pay interest, and remember inflation

With 1-2 years worth of spending money in it, it’s vital you keep your cash in the best paying interest account you can find. Be prepared to move it when the rate is cut. Also, you’ll need to increase your total buffer with inflation every year. In the good times, the interest might handle this, but if not you’ll need to top up.

Spend less than you generate: Perhaps 75%

Just as it’s good practice to spend less than you earn when working, it is sensible to spend less than you can when living off investments. There are two good reasons. Firstly, you can reinvest the spare money to grow your income stream, which will help you beat inflation – especially vital with fixed income. Secondly, should a financial disaster strike and your income nosedive, you’ll hopefully not feel the pain.

(This might sound like a platitude to frugal Monevator readers, but in the real-world people would be thinking fancy cars, gym bills, three foreign holidays, and all sorts of other commitments. This second safety margin is especially important if you retire from work very early – there’s hopefully a long way to go!)

Flexibility with lumpy income

A helpful thing about this system is it’s able to accommodate all kinds of income streams with ease, including passive income, part-time work, annuities, inheritances, capital sales, and more. Just lob it all in the buffer and adjust as required.

Tweak and tack as she goes

After a year or two you can revisit your figures and adjust if you’re being too generous to yourself – or even too mean! If your investment income rises dramatically, you can consider increasing your spending. If it dives, dial down your monthly debit.

You’ll also need to rebalance your portfolio as usual, of course, and move towards safer fixed income investments as you age. You also might increase your spending as the final curtain draws near, unless you’ve heirs to worry about – or perhaps spend twice as fast, as the case may be!

If you’ve made your own plans to live off investment income (or you’re already doing so) then please share your tips in the comments below.

This post is the latest part of a checklist designed to help you choose the best index trackers for your portfolio. By reviewing the checklist whenever you need to buy a fund, you’ll hopefully find it easier to compare all the trackers jostling for your attention.

Part one of the checklist dealt with some of the fundamental questions you need to answer when buying a fund, while part two focused on the all-important costs of ownership. Now we’re peering into the darker corners of the factsheet to look at some of the more overlooked stuff that can affect investing performance and the risks you’re exposed to.

Track record

How long has the fund been around for? The longer it has been hugging its benchmark like its long-lost mother, the better.

Look for:

• Five years as a bare and unsatisfactory minimum.
• 10 years plus is more like it.
• Don’t choose a new fund with an unproven record.

Sadly, you’ll be hard-pressed to find many trackers with a longer record than five years, but that situation is improving every year.

Tax status

Choose trackers with reporting fund status to avoid gains in off-shore funds being treated as income tax rather than capital gains tax. (There’s no need to worry about this wrinkle if all your investments are safely tucked up in ISAs or SIPPs).

Domicile

Your fund’s country of residence can lead to you paying excessive levels of withholding tax.

Withholding tax is levied by a country on the income and dividends earned by alien investors ¹. You’ll avoid the worst if:

• Your fund is based in the UK, Ireland or Luxembourg.
• It’s an accumulation fund.
• No income is paid – for example, if it’s a commodities fund.

Beware that ISAs and SIPPs offer no protection from withholding tax.

Assets under management

A large fund with lots of investors is less vulnerable to withdrawals by any single investor. Small funds are more likely to get wound up if investors flee, and the fund falls below the critical mass required by its creator.

In the case of ETFs, a larger figure can also suggest a more liquid fund that will help keep trading costs down.

Dividends

Funds that pay dividends can automatically reinvest them into buying more units to fatten up your total holding for the future, or else pay them straight into your account as a steady flow of income.

The following terms denote a fund that automatically reinvests:

• Accumulation (acc)
• Capitalised
• Reinvesting
• Total Return (TR)

Funds that payout the income instead:

• Income (inc)
• Distributing

Currency risk

You’re exposed to currency risk if the base or underlying currency of the fund is not denominated in your domestic currency. In other words, a UK investor holding a fund denominated in say, euros or dollars, will discover that the value of their investment:

• Increases as the UK pound weakens
• Falls as the UK pound strengthens

Many funds report in pounds, while their base currency is euros or dollars. But the reporting currency is nothing more than a presentational convenience. It’s the base currency that counts when it comes to currency risk.

UCITS approved

Make sure your fund is UCITS approved.

UCITS is a series of guidelines that set certain regulatory standards for funds sold in the EU. It’s not a belting read but, among other things, UCITS lays down the law on niceties such as counterparty risk, conflict of interest management, and the amount of information funds are required to disclose to retail investors.

Ownership

Most fund providers owe allegiance to their shareholders rather than to their customers. The customers only own a stake of the company’s funds, after all, whereas shareholders own the business!

The result is a fundamental conflict of interest between the fund providers’ aim to maximise profits at the expense of their customers and your goal to minimise costs at the expense of their corporate profits.

Though this battle is most fiercely fought in the active fund market, passive investors can limit the risks of exploitation by clocking the ownership structure of fund providers.

In order of preference, choose funds from companies that are:

• Mutual – The company is owned directly by its fund shareholders. The interests of company and shareholders are thus aligned like spooning lovers. Only Vanguard answers this call.

• Privately owned – Conflict of interest is a real and present danger but at least the company isn’t hostage to next quarter’s corporate earnings. Fidelity and Dimensional Fund Advisors are notable private concerns.

• Publicly owned – The most common and least desirable state-of-affairs. Baying shareholders demand CEO blood if profits aren’t pumped and customers squeezed.

Back in the real world

I don’t worry if I can’t find my perfect tracker based on all the criteria included in the checklist. Taken together, the entire rundown is a belt, braces and elasticated waistband approach.

Still, it’s worth knowing which factors are in play, and which represent the best choice of index tracker for you.

A few extra wrinkles remain, but they only apply only to ETFs. We’ll cover them in part four of the checklist. Nearly there!

Take it steady,

The Accumulator

1. That is foreigners, not martians![↩]