A dynamic way to create pension income

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.

To do that successfully, managers need a clear set of strategic beliefs about how different assets perform, and which risks will be rewarded under different market conditions. For instance, some believe that, over time, investors earn higher returns by investing in credit markets than by investing in government bonds, and so are rewarded for accepting the higher risks of issuer default that come with credit.

Managers also need a clear understanding of the drivers of risk. For instance, investors would typically think of a government bond issued by the US Treasury as lower-risk and less volatile than a leveraged loan issued by a sub-investment grade company. However, the prices of longer-dated bonds can move sharply in response to changes in expectations of the interest rate outlook. So the prices of longer-duration 10-year treasuries have historically been more volatile than “risky” shorter-term leveraged loans. That is because for leveraged loans the majority of volatility comes from credit risk, but for treasuries the volatility comes from duration. It is also important to understand the factor risks that are typically embedded in manager portfolios. For instance, high-dividend equity portfolios typically have a bias towards larger cap companies and to value as a factor. Managers want to ensure that any biases in their portfolios are consistent with their strategic beliefs. Research shows that good-value stocks will outperform over time, and so managers are likely to favour a tilt to value in their portfolios. By contrast, some believe that smaller-cap stocks outperform over time, so they will typically aim to moderate or neutralise a tilt to large cap. Balancing the different types of risk and reward is key to successful portfolio construction and to achieving their responsible income objective.

Because yields are changing all the time as market prices move, dynamic management is particularly important for multi-asset income portfolios. For example, over recent years we have seen very significant falls both in leading government bond yields and in the higher quality parts of the credit markets. These changes mean managers need to keep adjusting their portfolio allocations as they continue to seek alternative sources of yield and better ways to diversify portfolio risk. I believe it is important to stay widely diversified and keep aware of total return. We are seeing a number of esoteric but unproven income strategies – for instance new products based on aircraft and ship leasing. Some investors rotated out of investment grade and into high-yield credit last year, only to find the high-yield sector hit hard by falling oil prices and a severe setback for the corporate bonds of oil exploration and production companies. Some prefer a wider spread of strategies across credit and high-dividend equities. Currently, managers can earn a 4 per cent yield in some European equities, and they are looking to protect some of the downside risk by implementing a put option strategy. Credit markets are cyclical and so managers manage dynamically both their overall exposure to credit and their exposures to different underlying credit strategies. In particular, by altering the balance between fixed and floating rate credit strategies, managers can adjust their portfolios’ sensitivity to potential changes in the interest-rate environment.

As managers change portfolio asset allocations, correspondingly they also need to review the underlying strategies and investment manager products that they employ, and to make changes where they need to bring in different skills and exposures. So managing for responsible income means constant monitoring and re-evaluation, as managers continually balance the requirement for yield, the importance of total return, and an acceptable level of volatility.

I believe that an actively managed, globally diversified multi-asset income portfolio is the efficient solution for pension investors in the new age of pension freedoms. By opting for a multi-asset income strategy, pension investors can delegate to experts the multiple complex and demanding investment issues such as asset strategy, asset class correlations, constant monitoring, dynamic management and efficient trading. Of course, in an era of falling yields across multiple asset classes, multi-asset income strategies may not be able to deliver the level of yield pensioners want, nor with the level of volatility that they always find comfortable. But properly designed, constructed and managed, they can deliver a responsible income flow while preserving capital in the long term.

Mirko Cardinale is head of asset allocation Europe, the Middle East and Africa, at Russell Investments

Key points

Choosing an actively managed, globally diversified, multi-asset income strategy, it is still possible to achieve a realistic income yield.

Managers need a clear set of strategic beliefs about how different assets perform and which risks will be rewarded under different market conditions.

Because yields are changing all the time as market prices move, dynamic management is particularly important for multi-asset income portfolios.