Can income funds reduce sequence risk during economic volatility?

This problem can be particularly acute during times of weak economic turmoil. 

With markets predicting a US recession as early as 2020, can natural income producing funds help mitigate sequence risk?

Sequence risk 

Alan Chan, director and chartered financial planner at IFS Wealth and Pensions says: “Sequence risk is the danger that the timing of withdrawals from a retirement account will have a negative impact on the overall rate of return available to the investor.”

Sequence risk typically has less of an impact on lower-risk investments such as bonds, which generate predictable returns. 

Conversely, sequence of risk is often exacerbated by investments that go up and down, such as stocks, gold and real estate. 

A natural income producing fund generates and pays out income through dividends or interest received from its underlying investments Alan Chan

Mr Chan explains that this typically happens when markets are falling whilst still drawing the same level of income. 

“The risk is typically greatest for those in the early years of retirement and drawing an income from their funds,” adds Mr Chan. 
 
Craig Brown, investment specialist at Rathbones, says: “Paying a natural and regular income can help given that the requirement to draw on capital to meet income needs of investors may be eliminated, or at least reduced, depending on how much an investor wishes to draw.”

He adds:  “Paying income monthly can also help clients who need that regular income as they’ll often want to draw monthly, not quarterly.”

But Mr Brown stresses that the most important part of income is the “sustainability and dependability”. 

He believes there is little point in creating an optically high and volatile income stream especially if investors are reliant on the income to fund their lifestyle, and therefore more vulnerable to income shocks. 

Income funds amid economic volatility 

This view that natural income can fluctuate regularly with companies struggling to pay dividends during tough economic times is also shared by Mr Chan. 

“A natural income producing fund generates and pays out income through dividends or interest received from its underlying investments rather than the investor having to sell shares or units. Because no units are sold in the process, sequencing risk is mitigated.” 

Mr Chan adds: “However this also means that income will fluctuate regularly and some funds may pay out income quarterly as opposed to monthly.”

But David Bebb, chartered financial planner at Pannells Financial Planning highlights that natural income funds can be useful particularly to investors in the decumulation stage. 

Decumulation is the process of converting pension savings into an income for retirement.

Mr Bebb says: “Particularly for investors in the decumulation stage, having a fund that naturally produces income, whilst it does not remove sequencing risk, it does help reduce the market timing risk of selling units to generate the withdrawals required.”

Income funds versus capital growth 

But not all in the industry agreed that natural income strategies are the best way to avoid sequencing risk. 

Alistair Cunningham, chartered financial planner at Wingate Financial Planning, says he believes in a “world of a diversified multi-asset portfolio with the intention to achieve total positive return. 

“Whether that comes from income or capital growth should be irrelevant.”

According to Mr Cunningham, if only income strategies are used to mitigate sequencing risk then investors can miss out on the opportunities and tax allowances [posed by capital gain strategies]. 

Unless there is a specific requirement for income as a must, most people are better suited with total return strategies, he adds. 

Mr Cunningham explains: “There are some emerging markets, where income would be lower than some shares. [That does not mean] one would exclude them and miss out on capital growth strategies.”

Nathan Harris, chartered financial planner at Lothbury Group, disagrees with this view. 

He says income funds have lower volatility than equity funds because of the presence of yields. 

“A monthly dividend works better because they don’t need to sell capital units each month.”

He dismisses the idea that companies may struggle to offer dividends in tough economic times. 

“A company that is able to pay dividends is likely to struggle less than a growth fund with no yield which would struggle in a recession,” he says. 

But Mr Harris warns that investors adopting income strategies often comes with a “style bias”. 

“Many suggest that investors are better off with income funds.But it also means that you have a style bias and more valued approach.”

saloni.sardana@ft.com