David Jane of Premier Miton’s Macro Thematic Multi Asset Team considers the issues paraplanner face when looking to help generate retirement income for clients and how managing income in a multi-asset portfolio can help.
There is currently a rapidly growing category of clients entering, or nearing, retirement with money purchase pension schemes. Many are not inclined to buy annuities, post pension freedoms. Most of these clients will be looking for a monthly income to replace their salary. Commonly, they will end up with a total return strategy and sell units to fund their income needs. To us this seems an unnecessarily complex, and risky, approach. Income from assets is much more stable than capital value, so a prudently run income strategy will provide directly to the client’s needs, avoiding the sequencing risk that comes with a unit encashment strategy.
The challenge here is that, following many decades of low inflation and strongly rising capital values, few managers now consider the income on their portfolio as a relevant metric to manage. Funds have typically been sold on relative total return over a short-term time frame. Even managers running funds with income in the name, are often not managing the income that investors receive from a fund.
Consistent income
When we refer to managing the income, this must not be mistaken as targeting a yield. There are funds that target a yield level, meaning that if someone buys units today, they will receive that yield on their units, however if the unit price falls so will their income, and vice versa. We are not sure who such a fund might appeal to. We think managing the income should mean ensuring existing unit holders receive a consistent and growing payment over time, irrespective of what happens to markets. We think there is a huge market for such a product.
In practice, this means as a fund manager you are taking on an extra level of responsibility. Fortunately, this is much less onerous than it at first seems. In practice, income streams from most companies are much more stable than share and bond prices. In the case of bonds, the income you buy is the income you will receive to maturity, except if a default occurs. In the case of an equity, dividends may be variable, but many companies do try to provide a regular and growing payout to shareholders. Considering the market as a whole, dividends tend to grow consistently over time, although during Covid there were many cuts, overall dividends had recovered all losses by the end of 2021.
To manage the income in a portfolio, we forecast the bond income (which is predictable), and the equity dividends (which are less predictable). We consider this in view of the income we need to produce to meet clients’ expectations. If there is a shortfall, we can take corrective action well in advance. This throws up all manner of opportunities, as it forces you to consider the real value of assets.
For this reason, we think that consideration of income gives an advantage in terms of total return, particularly in this new environment of higher rates and higher inflation. A couple of recent examples highlight this.
During the covid crisis, a number of equities ceased their dividend payments as a result of economic uncertainty. At the same time bond yields fell precipitously, for the same reason. For an income manager, the lost income from cancelled payments was a problem. You needed to replace this income. With equities having fallen, and bonds having risen, the natural course of action was to buy more equities, funded by bonds. So, we sold government bonds at reduced yields to buy shares in those companies that were still paying attractive dividends. While we also sold shares where dividends were cancelled, net net we found ourselves buying equity during those difficult times. With the benefit of hindsight this turned out to be a good decision.
Another example would be the UK pension crisis last Autumn. Bond yields were driven higher, arguably because of forced selling, in a huge spike. As a consequence, some very attractive nominal yields were available for a period of time, in very good quality corporate bonds. We were able to lock in a high-quality source of income for several years into the future for unit holders. Again, this income driven opportunity led us to buy at what turned out to be very attractive prices.
These macro-opportunities are often repeated at an individual security level, where yield gives a signal that a bond or equity is mispriced for the long term.
In our view, an income strategy does not need to compromise total returns. Considering income can be an advantage, as it forces the manager to consider the real value of assets over time. In our view, the real long-term value of an asset is the cash it can return to its owners now and in the future.
[Main image: ferdinand-stohr-rzA7ZuI8M5o-unsplash]
