Retirees are currently seeking regular income of approximately 4 per cent to meet their annual spending requirements.
They understand taking income above that level is likely to result in capital erosion.
On the whole, the return available from balanced mandates has made this a sensible expectation that has been met in recent years. Since the 2008/9 financial crisis, cash rates have fallen and remain close to zero whilst bond yields have collapsed, thereby forcing retirees into alternative ways of generating the required income.
Even as recently as 2010, high quality government bonds offered a reasonable income yield with relatively low risk, and therefore provided a viable income solution.
By 2013, however, the continued fall in government yields made it necessary to complement government bonds with substantial allocations to high yielding corporate bonds.
Fast forward to today and the situation is worse still; despite below trend economic growth, the global hunt for yield has further compressed yields in low risk and high risk assets alike, with many government bonds now offering negative yields.
Regardless of whether they provide large, unexpected capital gains, it is impossible for government bonds to provide sufficient income to meet the above requirements, even if duration extension is considered. This leaves only junk bonds and high yielding equities as providers of genuine income.
Getting that 4 per cent
Thus, generating a 4 per cent income has required an increasingly risky investment strategy. Currently, the expected risk entailed in a 4 per cent income generating portfolio is double what it was in 2010.
While this increased risk has not yet been detrimental, quite the contrary, a strategy that solely focuses on generated income, without regard to the unintended consequences for portfolio risk, will likely shock investors at some point in the future.
For example, the least risky portfolio that currently offers a 4 per cent income yield consists of 37 per cent in cash and 63 per cent in high yielding corporate bonds. Such a portfolio would have generated a capital loss of 22 per cent during the financial crisis, in part because it no longer has the benefit of large gains emanating from government bond holdings.
Investor behaviour can compound the problem
While higher volatility is typically associated with higher ultimate returns, in practise this is not always the case. In particular, it is very difficult to maintain a long-term investment horizon during periods of portfolio weakness.
Experiments have suggested that losses are felt about twice as much as equivalent gains and therefore investors tend to prematurely panic out of loss making positions.
This loss aversion tends to be more damaging with expensive and/or high volatility strategies; it is therefore more likely with current (higher risk) income seeking portfolios than has been the case historically.
