Even though defined contribution investors no longer need to buy an annuity, they still need a reliable income in retirement.
With yields from leading equity and bond markets currently at a low – in some cases even negative – levels, it is hard for pension savers to pick investments that will achieve an adequate and reliable drawdown income. Of course, it is possible to choose a portfolio of exclusively higher-yielding investments, but this involves higher levels of risk and limited chances of income growth. That is not a suitable solution for most retired people, because ultimately it means consuming capital to reach for a high income.
I believe that, by choosing an actively managed, globally diversified, multi-asset income strategy, it is still possible to achieve a realistic income yield without impairing a portfolio’s total return. We call this investing for responsible yield.
To make sure of achieving a yield objective, we need to bring specialist expertise to each stage of designing, constructing and managing a multi-asset income portfolio.
What level of yield is realistic? When managers design multi-asset portfolios, for a given level of volatility there is a trade-off between income and growth objectives. As they ratchet up the target yield of a portfolio, the expected capital growth reduces at a progressively faster rate. That is why managers focus on targeting the highest level of income yield that can be achieved without reducing the expected total return – the responsible level of income yield. I believe income investors should be wary of targeting yields too far above this responsible level.
Modelling for multi-asset income portfolios suggests that, for UK investors, a realistic maximum for responsible income is currently about 4 per cent annually, after fees. To make sure managers can cover manager and distributor fees, and still allow for some capital growth, some tend to aim for a total return about 1.5 per cent higher than the income yield, that is, a target total return of 5.5 per cent.
To achieve a responsible yield objective, fund managers need to adopt the widest possible universe of investment options. That means going beyond the most familiar yield-generating asset classes such as equities and government bonds, and diversifying into a variety of higher-yielding investments such as loans, as well as emerging markets and high-yield bonds. They also include real assets such as property (via Real Estate Investment Trusts - Reits), and global listed infrastructure. Lastly, they include some absolute-return investments that typically have cash-plus return targets. These may not contribute an above-average yield, but because they rely on a wide variety of systematic and skill-based approaches, their returns patterns are less correlated with the other assets, and so can act as good diversifiers to help manage overall portfolio risk.
In the design phase, managers focus on selecting an asset allocation with a responsible yield objective and an emphasis on total return, bearing in mind also that they want to avoid unnecessary volatility. As they move on to the portfolio construction phase, they want to focus on selecting investment strategies and investment manager products that will help achieve the yield target and that can be used to balance risks across the portfolio.