The difference between accumulation and income funds is one problem new investors can expect to encounter as they start to invest their money into low-cost, passive index funds. Often shown as ‘ACC’ for accumulation and ‘INC’ for income, the slight distinction is often overlooked when choosing a fund and this can have surprisingly major implications for the growth of your future wealth.
When investing in funds, ‘INC’ stands for income and tells an investor that any dividend income the fund earns is paid out to the investor’s bank account. ‘ACC’ stands for accumulation which means all dividend income is automatically reinvested back into the fund.
This is an important distinction for us all to make as to achieve the powerful benefits of compounding over time (which I wrote about here) – investing in accumulation funds is the way to go.
What is the difference between accumulation and income funds?
The most notable difference between accumulation and income funds (ACC and INC as they’re otherwise referred to) is how dividends are treated in each.
A fund holding exactly the same underlying assets, i.e. Company shares, will have two classes of the fund known and accumulation (ACC) and income (INC).
In an accumulation (ACC) fund, any dividend income that the underlying Company shares payout is automatically reinvested into the fund for the investor.
In an income (INC) fund, instead of being automatically reinvested, the dividend income (which is otherwise the same as the accumulation fund), is paid out directly to the investors brokerage or bank account.
It’s worth mentioning that the dividends paid out from the INC class of the fund can manually be reinvested into the fund but it tends to be more efficient to simply invest into the accumulation (ACC) class.
The former is more suited for investors looking to grow their investments over time whilst the latter is for those investors seeking a regular, paid-out income.
There are other considerations to consider such as tax and risk but the main consideration should be taking advantage of the compounding opportunity that investing in accumulation (ACC) funds offers.
Investing in Company shares explained
In Accounting, there is a formula which states that Equity = Assets – Liabilities. Simplifying this, it basically means that what a Company is worth (equity) is equal to the net assets of the Company i.e. everything the business owns minus everything it owes.
This equity is split between all of the various investors into that business.
When a Company goes public, they list their shares on a public stock exchange such as the FTSE 100 here in the UK. These shares can then be purchased by the general public which gives individual investors small slices of ownership of these Companies.
Whilst Company share prices can, of course, go up or down based on the performance of the Company and the wider market sentiment, investing in Company shares (equities) is often considered a good investment as overtime these shares may appreciate in value and pay out dividends.
What does it mean to invest into a fund?
The problem with investing in a single Company’s shares as described above is that this is inherently risky. Let’s say you invested in a drinks manufacturer but then they accidentally poisoned someone, or new legislation meant their drinks were too sugary or any one of another thousand reasons, the Company may suffer and the stock price tank.
If this was the only Company you had invested in, your portfolio would tank with it. One way of protecting against this is diversification whereby you invest in lots of Companies across industries, sectors and geographies so if one or even a few fail, it only makes up a small fraction of your portfolio.
This is where funds come in. It would be a huge, expensive administrative burden to invest in hundreds of different Companies but it’s easy to invest into a single fund which holds the shares in these underlying Companies on your behalf.
For example. you can invest in a S&P 500 tracker fund which holds the shares of the 500 biggest Companies in the United States including Apple, Microsoft and Facebook. This way, your portfolio is diversified for you across different industries.
In this example, all of the Companies are incorporated in the US so it could be argued that this is not well diversified geographically but as most of these Companies are multinationals, this risk is partly mitigated.
A dividend is basically just a sum of cash a Company pays out to it’s investors (share holders) on a periodic basis, usually annually as a reward to the investors for their ownership. Dividend payments are typically more common for established Companies as younger Companies are not in a financial position to give back cash to investors as they need the cash to reinvest into their business.
When the Companies held by the fund payout dividends, the investors in the fund get their proportionate share based on how many shares of that company they own. This can either be taken as cash paid directly to your bank account or automatically reinvested into the fund and this is the difference between ‘INC’ and ‘ACC’ funds in a nutshell.
Some investors prioritise a portfolio of dividend-paying stocks as the income is more reliable. The caveat to this is that as the companies who payout consistent dividends tend to be more established and further along in their life cycle, they don’t tend to be as strong from a growth perspective i.e. they’re less likely to go from 0-100 in as short period as a new company may be.
Why does an accumulation fund help our investments compound?
Compound interest refers to the interest earned, plus the interest earned on the interest that has previously accumulated over time. For example, £100 at 5% interest is £105 after 1 year and £110.25 after 2 years. The growth increases over time as you start to earn interest on the interest.
So let’s talk about a simple example, let say you own £100 worth of a fund which pays out 5% in dividends each year, so £5. Let’s say the total annual return for this fund is 10% (which is roughly in line with what the S&P 500 returns each year on average)
Based on the above, the 10% return is made up of 5% from dividends and 5% from capital appreciation.
So if this were an income fund, after one year we would have £5 paid out to us in dividends and our portfolio would be worth £105 as there has been capital appreciation of another 5%.
Next year, our portfolio would grow another 5% and grow from £105 to £110.25. In year 2, our total return is £5.25 from capital appreciation and £5.25 from dividends so total returns of £10.5.
In an accumulation fund, our dividends wouldn’t be paid out but rather reinvested back into the fund. This means at the end of the first year, our portfolio would be £110. The gain of £10 is made up of 5% capital appreciation and 5% dividends.
In year 2, the capital appreciation of 5% on the £110 valuation would give us investment returns of £5.5 and the reinvested dividends of 5% another £5.5. The total increase of £11 is greater than the combined dividends and income of an INC fund which returns a combined £10.5. This difference is due to the benefits of compounding.
Whilst in this example the difference is small, hopefully you can see how significant compounding could be within an accumulation (ACC) fund.
In what situations should I invest in an income fund (INC) ?
Whilst accumulation (ACC) funds are superior for the compounding benefits, that doesn’t mean that income (INC) funds don’t have an interesting place in certain investors portfolios.
The obvious advantage of income (INC) funds is that they can provide a regular income. If, for example, you are retired and want your investments to provide a reliable, periodic income then an income (INC) fund may be the superior choice above an accumulation (ACC) fund.
It can also be claimed that an income fund may be suitable if you want to take your income from the fund you’re invested in to invest in other projects or funds. Having the dividend income deposited directly into your brokerage account allows for greater flexibility to move this money into other investments. In this case, the investor would still benefit from compounding.
It’s also important to understand that the dividends paid out in the income (inc) fund can be manually reinvested back into the fund as with the accumulation (ACC) fund but to avoid forgetting or the administrative effort of reinvesting, it’s usually easier to invest in the ACC class of the fund.
The difference between accumulation and income funds is simple – the former automatically reinvests your dividend income whilst the latter pays it out directly to your bank or investing account.
Despite the simplicity, this information is often overlooked which leads to new investors buying income (INC) funds which sounds better because who doesn’t want income right?
The problem is, these funds don’t allow for automatic, passive compounding of your investments over time and can therefore prevent you from achieving the wealth growth you would otherwise achieve.
That’s not to say income funds (INC) don’t have their place. Investors often use these funds to provide a reliable monthly income to cover expenses or to fund other investments.
As always, please remember I am an Accountant, but not your Accountant. In this post (and all of my others) I share information and oftentimes give anecdotes about what has worked well for me. However, I do not know your personal financial situation and so do not offer individual financial advice. If you are unsure of a particular financial subject, please hire a qualified financial advisor to guide you.
This article has been written by Luke Girling, ACA – a qualified Accountant and personal finance enthusiast in the UK. Please visit my ‘About‘ page for more information. To verify my ACA credentials – please search for my name at the ICAEW member finder. To get in touch with questions or ideas for future posts, please comment below or contact me here.