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 and it has never been so important for income investors and their advisers to recognise this difference.
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 and hence 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.
What Does this Mean for Income Investing in Retirement?
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 such as the CPI rate of inflation, plus 3%.
Most clients will be unable to generate sufficient income without drawing down some of their capital each year, and so advisers need to bake this into their planning, product and tax strategy. Investors need to withdraw a realistic level of income. Research at Morningstar has identified 2.5% as a safe level of starting income for the average UK retiree.
The income needs of people in retirement are seldom constant. Research by my colleague David Blanchett has showed 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.
It seems clear from the above that income investing is primarily a financial planning challenge rather than an investment puzzle. However, portfolio managers can help by clearly distinguishing between risk and volatility. We also need to look beyond traditional portfolio construction methods and focus instead on creating a portfolio of the best value opportunities.
A version of this article appeared in Investment Adviser magazine
