The use of capital to produce an income is one of the oldest and most widely held motivations for investment. While the objective remains the same, over time the profile of income investors has changed, and is now dominated by people either in retirement or approaching it, and who are seeking a replacement salary.
This shift in the investor base necessitates a change in the investment approach, but before looking at what changes need to be made, it is first worth considering how the needs of today’s income investors differ from those of the past.
The most important difference between the retirement-focused portfolios of today and the more general income portfolios of the past is that pension portfolios are more susceptible to non-investment factors such as demographic change, legislation and taxation. The impact of these factors has become especially clear over the last two decades as company pension provision has declined, and individuals have increasingly become required to take responsibility for their retirement savings.
However, the shift away from large corporate funds to personal plans has led to investment risks such as longevity and capital loss being focused on the individual rather than being distributed across a large group supported by a corporate sponsor. Personalised pension plans are less able than a large corporate scheme to adopt a long-term return-orientated approach, and instead must encompass the individual’s need for both income and security. This in turn has led to an ever greater focus on income-producing assets at the lower end of the risk scale, typically bonds and property.
The shift towards these assets may be demonstrated by data provided by the Investment Management Association. These show that the total size of the fixed income sectors in 2004 was £42bn compared with £126bn at the end of 2013, amounting to a growth of 199 per cent. In contrast, the assets held in growth-orientated equity funds have grown by only 128 per cent per cent over the same period.
This trend towards income-focused assets is likely to continue and even accelerate over the near future with the advent of greater access to pension funds at retirement. This huge change in the pensions market has already led to a precipitous fall in the use of annuities and is expected to presage a raft of new products and services as providers seek to accommodate the needs of clients with newly emancipated pension funds. While there will no doubt be a great variety of products launched, it is likely that income generation will be a unifying theme.
As ever greater amounts of capital are directed towards income-producing assets, the cost of that capital (that is, the return provided to investors) declines. This decline in returns can create a nasty feedback loop in which ever higher amounts of capital have to be used to generate smaller levels of income. The impact of this feedback loop is especially acute in the current cycle as central banks maintain interest rates at historically low levels. The impact of large amounts of capital chasing a limited number of income producing assets may be seen in the historic yield data of the income-focused IMA sectors (see chart 1). This shows that over the last five years, the yield from gilts and UK equity income funds have both fallen by 37 per cent.
Given this significant decline in yields and the low level of interest rates, it is unsurprising that investors are being forced to move further up the risk scale in an attempt to replace lost income. Evidence for this can be seen in chart 2, which details the capital inflows and outflows of the key income producing sectors over the last 12 months. This shows that capital has been removed from gilts and investment grade corporate bonds and invested instead into strategic bond funds. These latter products typically hold a significant portion of their assets in high-yield debt and therefore carry greater credit risk than investment grade funds.
As investors and their advisers have sought to increase the yield on their capital by accepting greater credit risk, fund managers have also been re-orienting their portfolios towards higher-yielding assets in an attempt to offer a competitive yield. Importantly, this sharp increase in credit risk is not necessarily obvious to investors as the funds’ aggregate exposure to investment grade debt may remain unchanged.
These less visible moves in risk at the fund level should be of particular concern to advisers as they indicate a possible distinction between the asset allocation structure created by the adviser and the actual exposure of the underlying funds. Such disparities tend to remain hidden while defaults and volatility remain low, but become obvious during periods of higher volatility and increased incidence of defaults.
This focus on superficially attractive initial yields reflects the fact that many traditional income portfolios are built with a specific target yield (say, 4 per cent), or are optimised to maximise the initial yield within the context of a target risk profile. However, both of these approaches tend to overemphasise the returns of the recent past at the expense of the long-term sustainability of the income. Few of us would accept a job that generated a high salary last year but that provides no indication of the next year’s likely income, yet this is in effect what happens when someone invests on the basis of the initial yield of the portfolio.
This prompts the question, how should income portfolios be structured?
While there is no single right answer, the key to success is to select the right tools for the job. For an income portfolio to represent an effective long-term replacement for earned income, it must focus on the sustainability of the income stream, not just the starting yield. Traditional capital market assumptions – the building blocks of a strategic asset allocation – do not take into account income stability and so must be replaced with new assumptions that do. Second, the asset allocation process must consider the income volatility of each asset class in addition to the expected yield, risk and total return.
This approach will naturally lead to a strategic portfolio with very different exposures to those of traditional income strategies. For example, a portfolio built in this way will tend to have a greater allocation to equities with high yields and low dividend pay-out ratios, as markets exhibiting these characteristics tend to suffer less from dividend cuts as the income provided is not dependent upon maintaining high levels of profitability. Additionally, such an approach will tend to favour fixed-income assets that combine credit spreads with interest rate exposure – such as emerging market bonds – over those bonds that are dominated by either yields or spreads (for example, gilts and high yield corporate bonds).
While these differences may result in a lower initial yield, a stability-focused approach should help protect the investor from overpaying for risky higher-yield assets and provide the adviser with a more realistic at retirement investment strategy.
Dan Kemp is co-head of investment consulting and portfolio management at Morningstar
Key Points
The most important difference between the retirement-focused portfolios of today and the past is that pension portfolios are more susceptible to non-investment factors.
Fund managers have also been re-orienting their portfolios towards higher-yielding assets in an attempt to offer a competitive yield.
For an income portfolio to represent an effective long-term replacement for earned income, it must be focused on the sustainability of the income stream and not just the starting yield.
