With the Reserve Bank of Australia (RBA) cutting the official cash rate to just 1.00% on 2 July and further interest rate cuts forecast by financial markets, retirees and investors face increased challenges in deriving enough income from their investments to meet their needs. This low-interest, lower-return environment may tempt some income-focused investors to abandon carefully diversified portfolios in the pursuit of higher income.
However, this often involves investing in a higher-risk and lower-quality portfolio – without the benefits of proper diversification. Watch out for the traps of becoming an income-chaser.
Given this low interest rate environment, income-oriented investors have three broad choices:
- spend less;
- reallocate their portfolios to higher-yielding investments; or
- spend from total returns instead of income alone.
Given that spending less is generally not a desirable option for most clients, we think it makes more sense to focus on the second and third options.
Higher risks associated with chasing higher yielding investments
Income-chasing investors may be tempted to reduce their exposure to high-quality bonds and broad share portfolios to increase their allocation to higher-yield, higher-risk bonds, hybrid investments and more concentrated portfolios of high-yield shares. Higher-yield shares are often concentrated in financials and utilities.
Unfortunately, not all investors would recognise and appreciate the higher risks involved when moving away from carefully constructed and broadly diversified portfolios with asset allocations that reflect their tolerance to risk and their long-term goals.
Investors who shift some of their fixed-income portfolio into higher-yield shares carry the risks of higher volatility and greater potential for capital loss.
A critical role of quality bonds is to act as portfolio diversifier and a buffer to share market volatility– not solely to produce income. Movements in bond and share prices typically have a low correlation. Don’t overlook the diversification role of bonds when interest rates are so low.
Adopting a total return approach
Given that the income only strategies mentioned above could be damaging to your portfolio’s overall health, we recommend our clients take a total-return approach to investing as an alternative to being an income-chaser. Total-return investing focuses on both the income and capital growth generated by diversified portfolio.
Keep in mind that the income-only and total-return approaches are identical to a point—that is, under each method investors spend the income or yield generated by their portfolio. It is only when investors need additional monies from their portfolio that the investor often faces a decision and the approaches diverge. The spending gap can be filled either by overweighting income-producing assets or by spending from the other piece of the total return, namely, capital appreciation.
A total return approach provides several advantages compared to an income only approach:
- Helps to maintain a portfolio’s diversification (investor risk exposure)
- Allow more control over the size and timing of eventual drawdowns in retirement
- Allows the portfolio to be more tax efficient and
- Increases the portfolio’s longevity
Conclusion
Many investors, particularly retirees, try to base their retirement spending solely on the income produced by their portfolios. This can lead to retirees becoming income-chasers or too frugal given the state of their finances.
Moving away from a broadly diversified portfolio and concentrating on certain sectors can potentially result in a less diversified portfolio, increased risk, decreased tax-efficiency and/or an increased chance of falling short of long-term financial goals. On the other hand, adopting a total-return approach focuses on the entire return earned by the portfolio rather than its individual components. As discussed above, it provides several important advantages compared with an income-only method.
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