Equity Income Funds

[Rids64]

I read a lot about the the benefits of 'compounding' by reinvesting dividend payments rather than taking the cash. However I am struggling to get my head round 'accumulation' and 'income' versions of the same fund. HL tells me that acc units benefit because the dividend payment is rolled into the price of the unit, hence acc units increase in value at a greater rate than inc units where the cash is paid out.

However my understanding is that dividends are paid out at a fixed price per unit held, not as a percentage of the value of the fund so in the case of an acc fund increasing in value but the number of units (and hence the divi payment) remaining the same surely I am effectively reducing the yield and not seeing any compounding benefit?

On the other hand if I take the cash from an inc fund and use that to buy additional units I should be increasing both the total value of my holding and the number of units in that fund, maintaining the yield and getting the benefits of compounding.

If, in the longer term, I want to live off the income would it make any difference to my final income whether I use acc or inc variants to build up the fund?

[Ozzie Osmond]

Imagine a brand new fund being created which offers investors either,

• 100 income units at £1 each, of
• 100 accumulation units at £1 each.

In the first year the fund has generated income of 10p per unit, or £10

• The value of 100 income units remains at £100, but you receive the £10 dividend.
• The value of accumulation units rises to £110

If the income unit holder reinvests his £10 he's then holding 110 units at £1 each, or £110
The accumulation unit holder still has 100 units but they're worth £1.10 each, or £110

Summary: Over time, the number of units will diverge but the overall value won't.

[Rids64]

Using those figures the income fund holder now has more units, so assuming nothing else changes at the end of year 2 if both fund holders decide to now take income from their holding the one with the income fund is an a better position because he has 110 units paying out £11 whereas the acc fund holder only has 100 units paying out £10?

[Ozzie Osmond]

Basic compounding of returns is easy to understand.

However, where you get the real benefit is if you're compounding tax free within an ISA or pension. There will be people today who have ISAs worth £500,000 even though the maximum amount that can be invested has typically been around £12,000 p.a. (This year it's £15,240)

• Someone starting an ISA for the first time in 2016/17 can invest £15,240 which will grow tax free.
• Someone who started an ISA in the past which has already grown to £200,000 can effectively invest in 2016/17 the annual allowance of £15,240 PLUS all of the income generated from their ISA fund in the year. With income at, say 4%, this means the person is effectively investing 15,240 + £8,000 = £23,240 into the tax free ISA environment.
• IF that person were to draw income from their ISA and then try to reinvest into the ISA (which would make no sense) they would of course only be able to invest £15,240 and not the full £23,240 figure

This tax free cumulation is massively valuable. If you ever hear anyone say "ISAs and/or pensions aren't worth doing" you can be pretty confident that you are in the presence of a fool.

[Rids64]

I appreciate that Oz and I would not withdraw the cash from the wrapper, just use it to purchase more units (and hence increase income potential) rather than allowing existing units to increase in value without increasing the income potential. Or am I just being a bit thick??

[Ozzie Osmond]

Rids64 said:

Using those figures the income fund holder now has more units, so assuming nothing else changes at the end of year 2 if both fund holders decide to now take income from their holding the one with the income fund is an a better position because he has 110 units paying out £11 whereas the acc fund holder only has 100 units paying out £10?

You can't draw income from an accumulation fund. In the same way you can't show me a round square, or reverse forwards into a parking space. The concepts are incompatible.

If the Acc unit holder wants income he has to "switch" from Acc units to Inc units. As illustrated above, he would then hold a different number of units and receive income based on that new number. So it would all balance out.

Note: If you intend to let a fund cumulate then depending on how you hold units it's possible that Acc units will be cheaper to hold than Inc units. Some platforms will apply an initial charge whenever a new investment is made, which can means that a dividend paid out from an Inc never quite gets fully reinvested. An Acc unit will always be cumulating the full 100%. As I said, the Inc reinvestment cost can vary depending how you hold investments.

[Ozzie Osmond]

Rids64 said:

Or am I just being a bit thick??

In finance there are no daft questions! Hopefully the above has covered your points.

OzOs

[Rids64]

Ozzie Osmond said:

If the Acc unit holder wants income he has to "switch" from Acc units to Inc units. As illustrated above, he would then hold a different number of units and receive income based on that new number. So it would all balance out.

Brilliant, the penny has finally dropped with me - using your example above the acc fund holder would sell his 100 units for £110 and uses that to buy 110 income units thereby generating the same level of income that the income fund holder would get. I can sleep easy now, thanks.