Money: Have trust in trusts

I TOOK a call from a potential client last week, Mr McNish. A few weeks previously he had asked for some investment recommendations. He had pounds 30,000 and wanted income. The call was to query these recommendations which he had received. "What I don't understand," he began, "is that you have suggested a portfolio of UK unit trusts with a gross income of 3.5per cent. But where is the benefit in that if I can get 7 per cent in the building society?"

A perfectly reasonable question, before attempting to answer it, I wanted to check my facts. "You wanted income and you agreed that your need was about pounds 1,000 pa but we also discussed inflation protection, right? You also said that you would have no call on the capital for at least five years."

"Yes. I want the income. I probably won't want the capital at all, but I don't want to lock it away for more than five years."

"We also agreed to assume inflation at 3 per cent per annum, that interest rates are more likely to fall than rise and that you were not concerned about short-term fluctuation of capital values?"

"That is true, but I still cannot see any advantage in accepting an income of half what I could get from the building society."

"OK" I said, "let me explain. First, let us work on the basis that interest rates do not fall over the next five years. Next, good-quality UK equity income unit trusts have a history of increasing both income and capital at a rate greater than inflation, but let us assume that over the next five years they only grow at 5 per cent. Do these seem reasonable assumptions, favouring, if anything, the building society?"

"Yes, that seems fair enough."

"Good. So, the building society will produce pounds 2,100 pa, that is pounds 10,500 over the five years. At the five year point, because of inflation, the buying power of the pounds 30,000 will have fallen to about pounds 25,762. Now, in the first year, the equity portfolio will produce only pounds 1,050 income but remember it is growing at 5 per cent pa so the total income over the period should be around pounds 5,800, that's about pounds 4,700 less than the building society. But, remember, the capital has grown at 5 per cent pa and stands at around pounds 38,300 after five years. So, if we add the income and capital gain, we have pounds 14,100 which is pounds 3,600, or around 34per cent, more than the building society. What's more, by year five the UK equity income unit trust portfolio should be producing an income of pounds 1,275 pa that's over 21 per cent higher than when first invested and equates to an income on pounds 30,000 of 4.25 per cent gross."

"Oh yes," he said. "I am beginning to see what you mean."

"There are no guarantees with the UK equity income unit trust portfolio, though we have assumed lower returns than have been the case historically. On the other hand, let's not forget that building society returns seem more likely to fall and we've assumed they'll be constant."

Mr McNish hesitated. "But isn't there a risk of the UK equity income unit trusts falling in value?"

"At some point, such falls are inevitable," I replied, "but the beauty of such funds is that falling values do not tend to result in falling income. As long as the end result is satisfactory, do fluctuating capital values matter much?"

"Well no, I suppose not. Yes, I see what you are getting at. The interest rate from the building society may look the best bet initially, but over time, the overall result is likely to be better with the UK equity income unit trusts.

"Exactly. Though if you'd needed the higher income from day one, we would have had to look at other options. We have a booklet called Defending Your Income. Why don't I put a copy in the post before you make your final decision?"

I sent the booklet; Mr McNish became a client this morning.

A free copy of `Defending Your Income' is available from Whitechurch Securities Limited. Call 0800 374413