16 Nov 2018 4 min read

Income illusion

By John Roe

Investors entering retirement may be tempted to look to higher-yielding assets to boost their income.

But could this result in greater concentration risk? And might dividends be more stable than equity volatility implies?


Once savers switch to using their investments to pay for retirement, the challenges they face change. This applies to defined benefit schemes paying members’ pensions or individuals drawing down their individual savings. In particular, if they sell assets at low prices to meet their cashflow needs that can hurt their long-term outcomes.

So given they’re worried about selling assets, investors naturally look at what assets can provide income as a way of meeting part or all of money they need. But while that instinct might be right, it can sometimes lead to the wrong conclusions.

Income chasing can be dangerous

While investment income is one way to avoid selling assets when investors need cash, trying to maximise income may not be a good idea as it can lead to a limited choice of investments, less diversification and potentially the wrong level of risk taking.

A preference for higher income should not impede asset allocation, which is the most important driver of outcomes. As a portfolio targets higher and higher income levels, the restrictions on how it invests get tighter. Assets that struggle to get much allocation in a high income portfolio, like inflation-linked bonds and equities with higher growth potential, play important roles in diversifying risk away from bonds and more stable equities.

Overall, the risk level of a very high income portfolio might be ok, but the constraints on what it owns will lead to less diversification and more concentrated risk drivers.

Of course, there’s no perfect portfolio for investors, so we may be able to achieve a somewhat higher income without feeling we’re causing problems, but there are limits to what we feel can be achieved in that way. Currently for specialist income portfolios we are achieving around 1-1.25% higher than on other multi-asset portfolios with similar risk, to balance these issues.

Income targets should change with market conditions

On a similar topic, some strategies target a particular level of income, even as market conditions and yields on assets change. Those portfolios become more constrained, and generally need to take more risk, when yields are low because fewer assets meet their income target.

As an example, if you consider three bond portfolios that would have generated 5% income in 2002, 2012 and 2017, the most recent portfolio requires a lot more risk taking as yields are generally lower. Investment grade corporate bonds get squeezed out and replaced by high yield and emerging market debt.


Equity income is surprisingly stable

Some investors, particularly defined benefit pension schemes, tend to focus on bonds for cashflows, because they are contractual in nature. Traditionally high quality government bonds and investment grade corporate bonds were the focus, though over time other less liquid and higher yielding bonds like loans and high yield have also been included.

It sometimes feels like these investors have drawn a hard line somewhere in the spectrum from government debt to equities. They treat everything with less risk than that cut-off as an asset with predictable cashflows, while ignoring the cashflows on other assets on the premise they’re too unpredictable.

But actually, how unpredictable are equity dividends per unit of initial investment? Well, the answer is they’re a lot less volatile than most people intuitively feel. I think this is because equity prices are volatile and so equity yields are volatile, but actually the value of dividends per unit of initial investment is much more stable.

Indeed, it's a little known fact that many UK investors in a globally diversified equity portfolio saw the sterling value of their income stream rise during the market falls of 2008, as the modest cut in global dividend payouts was more than offset by the fall in the value of the pound.*

One of the reasons that dividends per unit of initial investment is relatively stable most of the time is because companies recognise that investors dislike dividend volatility and so smooth their earnings. The variability of US equity dividends and earnings per unit of initial investment are shown below.

As such, we think there are benefits to investors including the full range of assets they own when considering sources of potential cashflows. Those cashflows that are less certain can always be reduced to allow a degree of caution over how much will really be received.  

Don’t obsess about income

Overall, we believe that investors should recognise that selling investments to meet cashflows only really has a material impact on end outcomes if the assets that they need to sell have fallen a long way and if the amount they need to sell is large. Proper diversification significantly reduces the first problem, while chasing too much income can impair the overall investment strategy. Allowing for cashflows on all assets, including equities, can be an effective way to make the problem a secondary consideration for many investors.

*Source: Thomson Reuters, Datastream World Index




John Roe

Head of Multi-Asset Funds

With failed football dreams behind him, John applies the same level of enthusiasm to investing and how to improve outcomes by battling behavioural biases. He leads on oil research, but also gets involved in a wide range of macro topics. That love of variety also explains his craft beer fascination. Hard to shut up, he’s a regular guest on Bloomberg, a conference speaker and an LGIM Director. His analytical thinking benefits from being an Actuary with an economics degree and having previously worked as a strategist at RBS.

John Roe