For most of our working lives, we invest to accumulate wealth, typically in retirement funds and in discretionary investments, such as unit trusts, property or shares.
When we reach retirement, however, the process goes into reverse. Our savings must provide us with an income, and the investments we use - typically in a living annuity - should reflect this. In the pre-retirement phase you invest primarily for capital growth, but in the post-retirement phase you need to invest primarily for income, although taking growth into account to ensure that your capital lasts.
Two fund management companies in South Africa, Bridge Fund Managers and Marriott, specialise in investing for income. They do this, in essence, by seeking equity and listed property investments that provide a reliable income flow in the form of dividends.
Marc Thomas, the head of marketing and distribution at Bridge, says return is made up of price and income. If you take a listed share, for example, the price is what the market will pay for it, while the income is the dividend the company pays annually to shareholders. (If you were investing for growth, you would normally elect to have dividend distributions ploughed back into your investment.)
The value of your capital is determined by the price, but this is of less importance for someone drawing an income than the income portion of the return, because, although the capital value may fluctuate as the markets rise and fall, the income from dividends is relatively steady, particularly from a reliable dividend-paying company.
Say, for example, you buy a share at R100, with a dividend yield of 5%. You will receive R5 a year on that share, even though its price may be down at R80 one day and up at R120 the next. If the company is a reliable dividend payer, this will provide you with a stable income flow, which may keep pace with inflation if the company adjusts its dividends upwards, year on year, as many do.
Says Thomas: “If you can live off the income alone, assuming the yield keeps pace with inflation, you won’t touch the capital, and you don’t even have to think about it. If you are not selling shares (or units in a unit trust fund), you need not be concerned about market volatility.”
Investing in this way not only provides you with a steady income; it provides the peace of mind you would not enjoy if you were concerned with return on capital. Plus, in the long term, the unit/share price should rise, giving you capital growth.
It also shields you from sequencing risk, Thomas says. This is the risk of the sequence of returns being not in your favour, which would happen if, once you start drawing an income, a period of poor returns precedes a period of good returns (see graph).
The nature of the portfolio
How would an investment focusing on income be structured?
Thomas says the portfolio will primarily invest in growth assets, because, although you can receive an income (in the form of interest) from a fixed-interest investment, such as a money market or bond fund, it does not rise with inflation.
A traditional multi-asset fund will not give you the desired income yield. “The average balanced fund gives only about 0.5% to 1.5% (after fund fees) in yield. However, your yield after costs in a total return income efficient portfolio can be as high as 6%,” Thomas says.
Starting dividend yields - the yield when you buy a share - are important, he says. A low share price normally gives you a relatively high starting yield, and vice versa.
Thomas says the appropriate asset classes are local and global equities, and local and global listed property. However, the tilt should be to local assets because:
- They are linked to local inflation;
- They provide higher yields;
- Offshore assets are subject to exchange-rate volatility; and
- There is a withholding tax on offshore dividends. (The 20% withholding tax on local dividends does not apply to living annuities.)
“This doesn’t mean the portfolio shouldn’t have an offshore component,” Thomas says, “but you shouldn’t draw from it - it would be too volatile.”
Income-focused funds aim for a yield of 5% or 6%, growing with inflation. Bridge’s funds include listed property, with some property investment companies focusing on South Africa, others more offshore. The equity portion is equal-weighted, to limit exposure to any single company. Companies that don’t pay dividends or that pay unreliable or low dividends are filtered out in the selection process.
Unless you were very wealthy, even in an income portfolio you would probably have to dip into your capital to a certain extent. “Not dipping into capital is an ideal situation,” says Thomas. “The income coverage ratio is the proportion of your drawdown income that is covered by asset income, and it should ideally be no less than 70 to 75%.”
Because many pensioners need a little more than yield, which presents sequence risk, Thomas says Bridge has designed a cash-flow strategy for its living annuity whereby a maximum of two years’ income goes into a cash portfolio. The bulk of the investment is in a yield-growth portfolio, and the income generated flows into the cash portfolio.
Bridge has adopted the same principles in a pre-retirement investment for clients in the last four or five years before they retire, which offsets risk in the same way.
Thomas says: “The advantage is that you get maximum exposure to growth assets and, with a few years to go, once you have a good idea of what your retirement income will be you can start preparing your portfolio to generate the income you need. You will also have two years’ income already available on retirement date.
"It offers protection against a market downturn affecting your ability to retire as planned, but if the protection is not needed because of good market returns, one to two years' income is not too much of a drag on the portfolio and still provides income protection against volatile markets once you are in retirement,” Thomas says.