Income focused approach exposing retirees to greater risk
Vanguard | 28 September 2020
According to new Vanguard analysis, investor portfolios built on a dividend-focused strategy will need to be 100 per cent allocated to equities and greatly elevate their portfolio risk, to meet most income needs in the current low yield environment.
Published today, Vanguard's latest research paper on the total returns approach An enduring solution for low yields found that investors using the rule of thumb 4% withdrawal rate as a target for income from their investment returns could have relied on a diversified portfolio of 50% equities and 50% bonds back in 2013. However, to obtain the same result today, investors will need to shift to 100% equities and almost double their risk.
"Many retirees who have experienced the recent reduction in dividends across the Australian share market are understandably worried given their reliance on these payouts to fund their retirement," said Inna Zorina, Senior Investment Strategist, Vanguard Australia.
"This scenario which requires a retired investor, arguably at the most conservative phase of their investment journey, to take on immense risk. It certainly presents a real challenge to the most impacted group in today's low yield and high volatility investing environment, and is probably not in their longer-term best interest," she said.
The research also debunked the popular rationale that investing in higher dividend-paying equities would generate greater overall returns relative to other equities. Data from the previous 25 years found that total returns are generally not affected by actual payout, as capital not used for dividends could be reinvested in projects that increased shareholder value instead.
The research further warned of the risk of tilting a portfolio towards value stocks, finding that the higher yield an equity portfolio delivers, the more substantial the amount of concentration risk the portfolio holds.
"Previously proposed changes to dividend imputation rules highlighted the potential risks that a high yield, concentrated portfolio may be exposed to. The current high volatility, low yield environment further affirms these risks," said Ms Zorina.
"The alternative to an income-oriented strategy is the total returns approach, where a portfolio's asset allocation is set at a level that can sustainably support the spending required to meet those goals and encourages the use of capital returns when necessary," said Ms Zorina.
The approach allows for the capital value of the portfolio to be spent during periods where the income yield of a portfolio falls below an investor's spending needs. It utilises both income and capital growth elements of the portfolio during the volatile periods for markets which inevitably occur, as long as the total amount drawn from the portfolio doesn't exceed the sustainable spending rate over the long term.
"While this approach requires the discipline to reinvest a portion of the income yield during periods where the income generated by the portfolio is higher than what is required for living expenses, it provides many advantages over the income focused method," said Ms Zorina.
"In addition to helping address unintended factor and credit exposures, this approach also addresses the main concerns that many retirees have around portfolio longevity," said Ms Zorina.
"Ultimately ensuring your portfolio includes an appropriate level of diversification matters for all ages and stages, and certainly even more in retirement. The total returns approach aims to provide for income needs without the risk trade off," said Ms Zorina.
With more than AUD $8.8 trillion in assets under management as of 30 June 2020, including more than AUD $1.8 trillion in ETFs, Vanguard is one of the world’s largest global investment management companies. In Australia, Vanguard has been serving financial advisers, retail clients and institutional investors for more than 20 years.