In recent weeks the Federal Reserve has adopted a new tone, suggesting that it will slow its programme of interest rate rises. The flagging economies of Japan, the Eurozone and the UK are unlikely to prompt a raise in rates either. It now appears that the global business cycle may be turning before interest rates have had a chance to lift. For income seekers, it means no imminent reprieve from the challenges they have faced since the financial crisis.
The question of how to create sustainable income in retirement is as pertinent as ever. It remains difficult to generate income from lower volatility assets, such as developed market government bonds. It means the phenomenon of a “scramble for income”, which has seen yields compressed across fixed income and equity markets , is still present in markets, forcing investors to look to higher risk assets for the same level of income. Quality can be compromised in pursuit of higher yields.
The long-held view has been that income generation should be “organic”: it should come naturally from the dividends on equities and the coupons on bonds. To take income from capital risks “pound cost ravaging” – where capital is sacrificed to create income, making it harder to create income in future. However, in today’s environment, to focus solely on income is potentially more damaging, as the pursuit of yield can draw investors into riskier assets.
This is particularly the case in the new pensions environment, where clients may remain invested for longer, but where significant drawdowns in capital could irreparably reduce a clients income prospects in retirement. Pensions have also become an important inheritance tax planning tool and as such, there may be an imperative to preserve as much of the pension pot as possible.
The total return approach
There are also sound investment reasons to prioritise a total return approach rather than an income-first approach. Inevitably, a focus on income restricts an investor’s universe. Prior to the Global Financial Crisis, those seeking income might have focused on traditional dividend-paying shares and corporate bonds. While there will be times when this approach works well, there are times – as the banking crisis showed – when it can go catastrophically wrong. Either way, there is a possibility of introducing extra risk into a portfolio because of a lack of diversification.
Income-generative sectors are unlikely to stay relevant permanently. That means investors are vulnerable to the fortunes of individual sectors. The banking sector may be the poster pin-up for this type of problem, but more recently it has happened in the tobacco sector, another traditional income stalwart.
Confining a portfolio to equities with income characteristics would have seen investors miss out on some major growth opportunities over the past decade, most notably in the technology areas. The ‘FAANG’ stocks have dominated markets and generated much of the growth, but don’t tend to pay dividends. Investors may also have missed out on defensive opportunities. Absolute return funds, for example, may not pay an income, but the stronger funds in the sector have proved a good protection against market volatility.
A broader investment universe
Looking at total return rather than just income can broaden the investment universe. This is particularly important at a time when the economic environment is uncertain. Diversification is a good defence against volatile markets.
Any strategy that seeks to create income while sustaining capital growth should also consider an allocation to alternative investments. Financial markets evolve. New products come to market and innovation continues. Some won’t be appropriate, but it is vitally important to analyse any potential opportunity. In recent years, more of these new options have come to market, bringing distinct and diversified income streams. These are also less likely to be arbitraged away, as fewer people have the resources to analyse them.
At Cazenove Capital, we have built a dedicated fund to house this type of investment: the Diversified Alternative Asset fund has been built solely for use with our private clients and inflows are monitored carefully to manage liquidity. This incorporates areas such as infrastructure, specialist property – care homes, social housing – alongside aircraft leasing and pop music royalties. The portfolio provides an uncorrelated and diversifying source of income and capital growth. Neither the income stream nor the capital has a significant relationship with other asset classes.
At a time when the suitability of client risk profiles is under increasing scrutiny, it is important to ask whether a portfolio that doesn’t look broadly and analyse new investments as they emerge continues to meet an adviser’s investment criteria. We believe it’s important to delve into these areas and see whether they are viable. Relying on “traditional” approaches risks missing the important point that markets evolve over time.
Neglecting capital growth in favour of a relentless pursuit of income risks losing sight of the client’s real goals. There are no tax constraints in a pensions’ environment, so it doesn’t matter where the return comes from. Total return should be the priority for those investors looking for long-term income without compromising capital.