The combination of low interest rates, reduced dividends and forecast lower return expectations has created a headache for those approaching or already in their draw down years. Some may be tempted to reinvest into other perceived “safe” investments, which are offering higher income returns such as high yield bonds, hybrid securities or equity-income strategies. This can increase the portfolio’s risk profile and may not be in the investor’s long-term best interest.
Historically, many retirees and advisers have used the 4 per cent rule of thumb when considering an appropriate level of income to draw from their savings when they retire. That is, drawing 4 per cent of the portfolio value out each year as income, without a substantial risk of running out of money too soon, assuming the portfolio was yielding at least 4 per cent.
If we look back, in 2013 an investor following this 4 per cent rule could have used a balanced, diversified portfolio of 50 per cent Australian shares, 25 per cent Australian bonds and 25 per cent term deposits to get that 4 per cent yield. Not taking on too much risk, including downside protection of bonds and the peace of mind that term deposits provide to many.
But given the current investment outlook, income sensitive investors now need to rethink how to earn enough income to meet their spending goals. To maintain the same level of income may involve taking on higher levels of risk, often to the detriment of that protection and peace of mind.
There are four main ways that tend to be considered on this front – you could invest in higher yielding bonds, invest in hybrid style securities, increase your allocation to equities or introduce higher yielding equities.
All of these options come with the potential for investors to take on, in some cases, much higher levels of risk than an investor may otherwise have an appetite for by decreasing the defensive investment choices which balance out portfolios and mitigate equity risk.
For example, that same investor described earlier would today have to shift to a portfolio of 100 per cent equities to get the same 4 per cent yield. Shifting the portfolio that dramatically almost doubles the risk built into the portfolio versus the 2013 example, removing the benefits and protection provided by portfolio diversification through investing in other defensive asset classes such as fixed income.
But there is a different way to plan for the draw down years which takes a broader view than just concentrating on income returns.
If your starting point focuses instead on the Total Return (all sources of return) of your portfolio versus just the income or dividend yield, and in collaboration with your adviser, introduce a prudent spending strategy, you can keep control over both the risk level within your portfolio and how much income you draw out each year.
Unlike an income-oriented strategy which generally uses interest/dividends as income and preserves capital, the total return approach accepts that in some years the drawdown of capital may be necessary. This for some will require a significant shift in thinking, as for many the income approach appeals because the underlying nest egg isn’t drawn on.
However, a dramatic shift in investing environment and outlook is demanding investors rethink the costs – and risks – of maintaining an income-oriented approach in the future.
To implement the total returns approach, goals and risk tolerance should first be considered. This informs an appropriate asset allocation at a level that can sustainably support the spending required to meet those goals, with the use of capital returns when necessary.
For example, during periods where the income yield of a portfolio falls below your spending needs, the capital value of the portfolio can be spent to make up the shortfall. As long as the total amount drawn from your portfolio doesn’t exceed the sustainable spending rate over the long term, this approach utilises both income and capital growth elements of the portfolio during the volatile periods for markets which inevitably occur.
It will require a regular review and future projection analysis of your ability to fund your longer-term financial goals. It also requires the discipline to reinvest a portion of the income yield during periods where the income generated by the portfolio is higher than what is required for living expenses.
A Better Alternative
Adopting a Total Return approach allows you to separate your spending strategy from your portfolio strategy which can ensure the risks don’t creep up to a level out of step with your risk tolerance.
In addition to the benefit of smoothing the source of drawdowns between income and capital growth throughout retirement, it can also allow for better diversification of risk across countries, sectors and securities, as well as increase your portfolio’s longevity.
For some income focused investors this approach may require a mindset shift but the current and forecast environment demands this is given careful consideration. As always, its best to discuss your individual circumstances with a licensed, professional adviser.
To find out more about how any of these measures may be of assistance in your individual circumstances, please contact Gordon Thoms or David Conte at Calibre Private Wealth Advisers on ph. (03) 9824 2777 or email us here.
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