The search for income is becoming increasingly desperate in a world of very low yields.
Consequently, income-focused investors face a difficult choice between higher volatility or higher risk in their portfolios. That sentence may strike you as odd because the financial services industry has typically equated risk with volatility, but in reality, they are different. It never been so important for income investors and their advisers to recognise this.
In this context, risk is defined as the potential for a permanent loss of capital or, more precisely, a reduction in the value of an asset that is not expected to be recovered within the investment horizon. Permanent losses are primarily driven by valuation (overpaying for an asset), fundamentals (asset quality deteriorates) or financing (gearing and redemptions).
In contrast, volatility describes average deviation in asset prices. While volatility is relevant for income-focused investors due to the well-known impact of path-dependency, the former is most important as income investors are particularly exposed to a significant decline in asset prices. Such declines tend to be valuation driven, which is why investors must avoid the siren song of low-volatility, income-producing assets that are severely overpriced.
This risk appears to be highest in fixed income markets. Consequently, the asset class landscape for income investors has been turned on its head as we would now regard equities and more volatile credits such as local currency emerging market debt as a lower risk source of income than government and investment grade bonds, as the latter is priced to deliver negative real returns over the next decade.
So what does this mean for advisers seeking to generate income for retirees? First, given the importance of valuation as determiner of drawdowns and the success of an income investment strategy, we advocate a valuation-driven approach that seeks to own under-priced assets and avoid those that are overpriced. Such an approach can be expressed as both a ‘natural income’ portfolio or a strategy aimed at delivering a particular return outcome – i.e. inflation plus 3 per cent.
Second, most clients will be unable to generate sufficient income without drawing down some of their capital each year, so advisers need to bake this into their planning, product and tax strategy.
Third, investors need to withdraw a realistic amount. Research at Morningstar has identified 2.5 per cent as a safe level of starting income for the average UK retiree.
And finally, people’s income needs are seldom constant. Research by my colleague David Blanchett has shown that spending in retirement typically exhibits a ‘smile’ pattern: starting off high as people remain fit and have more leisure time, before falling as activity levels drop and eventually rising again as the requirement for additional care increases living costs. Portfolio planning that takes account of this expected spending pattern is likely to result in a better outcome for investors.
