Allocating for income

Living off yield alone in retirement is a worthy goal, but it creates issues.

Summary: While there are many ways to tilt the allocation of a portfolio to drive higher income, focus on building a multi-asset portfolio to generate income and growth.
Key take-out: Rather than live totally off portfolio income, maintain a target allocation of major and minor assets and periodically align their portfolio to this allocation, including when funding a portfolio drawdown.
Key beneficiaries: General investors. Category: Investment portfolio construction.

A direct result of central banks intervening in markets to lower interest rates and bond yields is the increased demand they have created for other higher-yielding assets.

While a tilt towards yield, and in Australia to franking credits, is sensible – if restraint is not exercised investor portfolios can become unbalanced. And, at this late stage in the hunt for yield, they can take on unrewarded risk. Here, let me challenge some popular yield-portfolio allocation decisions.

You need not live off portfolio income alone

Many investors are determined to live off yield alone and leave their capital intact. While this is a worthy goal, it creates a number of issues. First of all, for a retiree it means they will do a bad job spending their kids’ inheritance (who based on today’s longevity will be self-funded retired seniors too when the investor passes away).

Secondly, it tends to promote over-representation of high-yield, low or nil growth assets at the expense of growth assets, which could put the portfolio at greater risk of inflation. Remember, a break-out of high inflation is the biggest risk to retirees, not depressed yields and share prices. Prior to the recent decline in interest rates many investors were comfortably overweight in generous deposits yielding about 6% – although not as comfortable as those earning 16% many years ago. With lower yields on offer, some may now be underweight.

Figure 1: Investment pornography? 1989 term deposit rates offer by National Mutual
Graph for Allocating for income

A third issue with attempting to live off income only is a portfolio can become out of balance over time, for instance after a rally in share prices. Right now it is quite possible a number of moderate investors have drifted up in equity mix becoming more aggressive investors – making them more sensitive for any “sell in May and go away” correction.

Rather than live off portfolio income, I would suggest investors maintain a target allocation of major and minor assets and periodically align their portfolio to this allocation, including when funding a portfolio drawdown. Figure 2 shows a simplified representation of a three-step process to follow to keep your portfolio in balance and fund a pension at the same time. The more income the portfolio generates the less portfolio selling is necessary; however, the more the portfolio enjoyed a spurt in share-price growth the more defensive selling should be done.

Only high dividend stocks give you the income you need

Recently I showed readers how to make their own homemade dividends and pointed out that investing in low-yielding CSL (2% yield) could contribute just as much to a quality retirement as CBA (5% yield). By following the steps shown in Figure 2, investors can essentially put in practice their own dividend policy by applying this methodology not just at the asset class level, but at the individual shareholding level. For a young accumulating investor adding funds to super, this means working out which assets and stocks to buy rather than sell.

It is interesting to review Australia’s advanced superannuation system and see how many large (industry) super funds have specific fund choices tuned to the needs of retiree investors. Yes, all offer tax-free compounding pension funds, but these still use the same “baby bear, momma bear, father bear” low-to-high growth asset allocation choices common to young accumulators. Aside from the introduction of progressive equity de-risking life stage funds,  I can’t find any providers that promote special retirement funding asset allocations, perhaps chasing high-yield stocks or franking credits. On the surface these professional investors do not seem to specially tailor their asset allocation to suit income-seeking retiree investors. This raises the question: are they not as smart as they should be? Or do they, deep down, believe that the markets are rewarding for all investor types regardless of their income appetite, and special allocations for income aren’t needed?

Dividend paying stocks don’t necessarily outperform

During this period of dividend fever it’s hard to show that high dividend paying stocks don’t outperform. In fact, the meteoric rise in share price and price/earnings ratio of big dividend paying stocks like CBA and Telstra supports a view that high-yielding stocks are above-average performers.

Late last year I was taken by a chart that showed that the top 20% dividend paying stocks in the US sharemarket for 50 of the last 60 years trading at a reasonably stable 20-30% discount to the broader market as measured by price/earnings ratio (shown here again in Figure 3). In the last few years the hunt for yield has been so great that these shares now trade at market or higher multiples.

Recently I’ve look into valuations of one of my favourite asset classes, infrastructure (see Infrastructure’s game plan) and found that these, sometimes considered “bond substitutes”, are now trading on valuations 20% higher than usual and on yields similarly lower.

Note, I’m not predicting the imminent collapse of CBA and Telstra share prices. In fact they could justifiably rise further, measured against the next best thing of low deposit yields. I’m merely pointing out that their price rise has been supported by an understandable, insatiable appetite for yield.

One day, probably after more rewarding interest rates look to be around the corner, this investor interest will dissipate leading to a decline in price or at least a stalling in share price growth. Historically, banks like CBA traded at a small discount to the market not a premium (e.g. traditionally trading on 13 not 15).  Lastly, on this growing sensitivity of “Mum and Dad” portfolios on bank share performance, I was surprised also by a recent slide (Figure 4) from a presentation by Zurich, which totalled Australian household investments in local banks. It adds up to a whopping $1.3 trillion – if you count both $500 billion invested in shares and income securities and nearly $800 billion in deposits. Actually I’m not surprised, I’m worried. I hope David Murray and his commission are too!

You don’t always get to keep the extra 1-2% from higher-yielding debt securities

During the good times it is not hard to find a debt security that will pay you an extra 1-2% yield. However, when bad times come the capital value of these investments can decline by 10 times this annual premium, wiping out the cumulative income benefit and worse become illiquid and frozen. Yes, some investments can be held to maturity for price to recover, but that’s not the point of defensive investing.

I’m pretty certain that over the lifetime of a retiree investor, they will make far less money from the cash and bond part of their portfolio than they will from their share portfolio. The only reason then we have a defensive portfolio is to shield the portfolio when an inevitable decline in the sharemarket arises. The higher the defensive character of the portfolio the more higher growth equities can be held. As shown before (Build your own hybrids) I still believe over the long term investors will make more money from 50 cents invested each in a bank share and deposited than $1 invested in an income security.

Figure 5 shows the capital price of Australian bonds (nominal and inflation linked), cash and hybrid income securities during the Greek sovereign debt crisis when domestic and international share prices fell. The key message from this slide is that the decline in the portfolio value would have been less with higher-quality (lower yielding) defensive investments than with (higher-yielding) Australian hybrid securities.

Central banks get to set cash rates and sometimes they are profitable versus inflation and sometimes less so or not. It is risky late in the cycle of investor repression to go hunting for higher yield debt investments. The marginal return (or “spread”) you will get could be poor payment for the substantially higher risk you take. You will be at the back of the herd of yield hungry investors, and you know what the view from there looks like!

Income investing has become a crowded investment – be cautious!

In summary, while there are many ways to tilt the allocation of your portfolio to drive higher income, my message here is to question if you need to and whether now is the time to do so.

While there is an absence of bad news, and volatility is low, you probably don’t need to take action with a well-diversified portfolio – especially if you were one of the early income portfolio builders. However, if you are wondering where to put new money I would go looking for a new investment theme.


Doug Turek is principal adviser of family wealth advisory and money management firm Professional Wealth (www.professionalwealth.com.au). The comments published are not financial product recommendations and may not represent the views of Eureka Report. To the extent that it contains general advice it has been prepared without taking into account your objectives, financial situation or needs. Before acting on it you should consider its appropriateness, having regard to your objectives, financial situation and needs.

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