Natural income or total return? Choosing the right strategy for clients in retirement
30 Apr 2021
As clients near retirement, their focus naturally turns towards the best way of taking an income from their pension pot. Hymans Robertson’s William Marshall takes financial advisers through our thinking when it comes to achieving the appropriate balance between strategies focusing on natural income and total return.
I want to begin by stating that deciding between a natural income (e.g. dividend or interest-focused) or total return approach isn’t a binary decision: income-oriented stocks have growth potential, and total return strategies are often underpinned by stable dividend streams. Nevertheless, it is an important matter to consider.
The benefits of natural income
With natural income, dividends are paid out as they are received. That means there’s no pressure to sell stocks at the wrong time, reducing risk.
Dividends tend to be resilient – for example, despite all the uncertainty around COVID-19, many companies in the US and Japan continued to grow dividends.
Watch out for the pitfalls
With swings come roundabouts. Be wary of too much emphasis on the word “yield”: the term tends to be used interchangeably with income, but it isn’t the same thing. Income paid out is real money. Yield has many definitions but by far the most common is the ratio of income divided by price. This means a stock’s yield can go up due to income going up and/or price going down.
The current low yield levels mean clients reliant on natural income face a dilemma: accept a lower level of income, move into higher yielding stocks or asset classes, or start to redeem capital (that is, effectively become a total return investor). Accepting a lower income might be seen as the prudent thing to do, as it avoids the need to redeem assets. But there's a difference between the theory and the reality. Investors have fixed costs to meet and the scope to accept lower income for a sustained period may not actually exist.
Equity investors seeking to increase yield may be tempted into higher yielding sectors. However, this must be a considered approach as it has the potential to increase investors’ risk, by potentially being concentrated in specific asset classes and sectors. The table below shows two of the currently highest and lowest yielding UK sectors.It also shows the performance of these sectors relative to the FTSE All-Share over the 12 months to 30 September 2020. As a result of chasing yield, based on the numbers below, there is risk that investors are overexposed to historically more volatile sectors such as the oil and gas and financials, and away from more growth-oriented sectors, such as technology.
Finally, dividends may be resilient but they aren’t immune to market challenges. Organisations may choose to suspend or reduce dividends, with investors taking a hit on income. As ever, your strategy needs to focus on diversity, using robust scenario and stress testing to reduce volatility and increase predictability.
In conclusion
One size doesn’t fit all. On balance, we tend to favour a total return approach over natural income, focusing on portfolios with a strong income-generating element to help complement capital growth, all with the aim of providing predictability of returns to support our clients’ needs.
Definitions
Natural income comes from dividends, interest or coupons. The income funds retirement.
Total return comes from generating returns from income or capital. Regular pot withdrawals fund retirement.
For Professional and Intermediary Clients Only
Hymans Robertson Investment Services LLP is authorised and regulated by the Financial Conduct Authority. One London Wall, London, EC2Y 5EA, telephone number 020 7082 6000. You can find it on the FCA register under firm reference number 927111.
The value of investments and the income from them may go down as well as up and neither is guaranteed. Investors could get back less than they invested. Past performance is not a reliable indicator of future results. Changes in interest rates may also impact the value of fixed income investments.
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