David Jane
Premier Miton Macro Thematic Multi Asset Team
For information purposes only. The views and opinions expressed here are those of the author at the time of writing and can change; they may not represent the views of Premier Miton and should not be taken as statements of fact, nor should they be relied upon for making investment decisions.
There is currently a rapidly growing category of clients entering, or nearing, retirement with money purchase pension schemes. Many are not inclined to buy annuities, post pension freedoms. Most of these clients will be looking for a monthly income to replace their salary. Commonly, they will end up with a total return strategy and sell units to fund their income needs. To us this seems an unnecessarily complex, and risky, approach. Income from assets is much more stable than capital value, so a prudently run income strategy will provide directly to the clients’ needs, avoiding the sequencing risk that comes with a unit encashment strategy.
The challenge is that, following many decades of low inflation and strongly rising capital values, few managers now consider the income on their portfolio as a relevant metric to manage. Funds have typically been sold on relative total return over a short-term time frame. Even managers running funds with income in the name, are often not managing the income that investors receive from the fund.
When we refer to managing the income, this must not be mistaken as targeting a yield. There are funds that target a yield level, meaning that if someone buys units today, they will receive that yield on their units. However, if the unit price falls so will their income, and vice versa. We manage income with the aim of delivering consistent and growing payment over time, irrespective of what happens to markets. We think there is a huge market for such a product.
In practice, this means as a fund manager you are taking on an extra level of responsibility. Fortunately, this is much less onerous than it at first seems. In practice, income streams from most companies are much more stable than share and bond prices. In the case of bonds, the income you buy is the income you will receive to maturity, except if a default occurs. In the case of an equity, dividends may be variable, but many companies do try to provide a regular and growing payout to shareholders. Considering the overall market, dividends tend to grow consistently over time, although during Covid there were many cuts, dividends had recovered all losses by the end of 2021.
FTSE World dividends and capital value track each other, but dividends are more stable
Source: Bloomberg from 15.06.2007 to 10.05.2023. Data indexed to 100. Past performance is not a reliable indicator of future returns.
Not all income is created equal
It is also the case that dividend cuts tend to be concentrated in certain industries and regions during bear market phases, meaning they are relatively easy to manage compared to capital value declines. Basically, you know in advance the level of commitment a company has to its dividend, does it see it as variable or as something they must grow over time.
This is good news for those looking to use a natural income strategy rather than unit encashment, a good income manager should be able to provide a very stable income that grows over time, while even the best managers struggle to avoid material capital drawdowns in bear markets. The effect of drawdowns on unitholders is they are forced to sell proportionately more units in weak markets and less in strong, the dreaded sequencing risk.
A material drawdown shortly after retirement has a huge impact on the expected long term outcomes, compared to an insignificant impact from a natural income strategy. This is simply because the unit encashment strategy must sell much more units than expected early on.
We are big believers in natural income for those clients looking to draw income from their investments for this and other reasons. In a later note we will discuss the practical aspects of managing income and the potential benefits to total return.
