One of the most common questions I receive about retirement income planning is, how realistic is the idea of relying on natural yield in one’s portfolio to meet retirement income needs. The rational is that by relying on the natural yield from their portfolio, retirees can avoid drawing on their capital or selling fund units, thereby avoiding the dangers of sequence risk.
The natural yield approach contrasts with the total return approach, which essentially ignores the difference between capital growth and dividends, and instead seeks to draw income from both in a sustainable way.
The natural yield approach is bandied about by some asset managers, who promise ‘stable natural yield’ to retirees. So it’s no surprise that the consumer financial press is awash with articles on natural yield (See this, this, this and this). This one by my friend Sam Brodbeck in the Telegraph sums up the approach rather nicely:
“The idea is to ignore the fluctuating capital value of a portfolio and only take the natural yield. An original £100,000 investment might dip to £80,000 or rise to £120,000 in terms of value, but investors should resist the urge to touch the capital.’
The trouble is, this approach is bonkers for several reasons.
- Dividend and bond yields fluctuate significantly over time. This means that a retiree’s income will change significantly from year to year. This creates an unacceptable level of volatility in their income and makes budgeting nearly impossible.
- Once adjusted for inflation, natural income yield is highly unlikely to meet the spending pattern of most retirees, bar the very wealthy.
- Even if yield appear stable in percentage terms, the income received in £ terms will still be calculated in relation to the outstanding capital, which invariably fluctuates over the retirement period.
- Proponents of a ‘natural yield’ retirement strategy have offered little empirical evidence to back their theory. They erroneously focus on recent percentage yield of the FTSE 100 or FTSE All Share. Most retirees are more likely to have a portfolio consisting of bonds and shares, at the very least. And it’s crucial that any retirement income strategy works over a very long period and under various market conditions, including the extreme ones!
The Big Test
So in this research, I set out to examine the natural yield approach to retirement income, using empirical data. This time, I’ve used the Barclays Equity Gilt Study (BEGS) dataset from 1900 to 2015. Unlike the DMS database which I used for my other research, BEGS decomposes equity and bond returns into capital growth and income yield.
- I created a portfolio consisting of 50% UK equities and 50% gilts, which is rebalanced annually.
- I examined the real natural income on a £100,000 portfolio for retirement periods starting in 1900,1905,1910,1915 …. to 2005 and 2010. I also included a retirement period starting in 2008, just to take my total number of scenarios to 20!
- Based on the dataset, I looked at a retirement period of 30 years. Retirees starting after 1985 haven’t completed the full 30 year period yet, so I’ve presented their results for the period covered so far. For instance, a retirement period starting in 1990 (Class 90) has had 25 years so far and a retirement period starting in 2000 (Class ’00) just 15 years!
- The real natural income is the natural yield from the outstanding portfolio, adjusted for inflation. I work on the basis that no income is taken from the capital and the retiree relies entirely on the natural income of their portfolio.
- No fees/taxes are applied to the portfolio. Obviously, the net natural income would likely be lower after fees/taxes and the key points hold regardless.
The chart below shows the real natural income from the portfolio over the subsequent 30 year period (or less where applicable i.e. retirement dates starting after 1985).
As you can see, regardless of the retirement date, a retiree relying only on natural income experiences a significant fluctuation in their income from year to year.
Take for instance, our Class 1900 who started their retirement with a natural income of £4,550. By the second year, their inflation adjusted income fell to £3,897 and by the 5th year it was £3,005. But their troubles were only just beginning; by their 20th year in retirement, their real income yield had fallen to £1,024! I know no retiree on the planet who would consider these levels of fluctuation in their annual income to be acceptable.
In the second chart below, I show the first year’s natural income, as well as the lowest, the mean and the highest real natural income over the entire retirement period. I also show the ‘income volatility’ in %, which is the standard deviation from the mean income over each retirement period.
The implication is that a retiree living off natural yield may or may not start off with a decent income in the first year of their retirement. But they should expect their income to fluctuate like a yo-yo from one year to the next. And once you add in the effect of inflation, this yo-yo effect (income volatility) is simply unacceptable for most retirees.
Of course, a proponent of natural yield will argue that a natural yield portfolio will specifically overweight high-yield assets such as high-dividend equities, commercial property, REITs and high-yield bonds. A recent paper by Vanguard lays bare the flaws of this thinking but I want to pick out these key drawbacks
- High-yield asset classes such as commercial property/REITs, hgh-dividend equities and high yield bonds tend to have large drawdowns, particularly during stressful market conditions. The chart below shows the cumulative total returns during the global financial crisis (12 October 2007 to 9 March 2009) of major asset classes, including high-yield ones during the financial crisis of 2008.
As you can see, income yielding asset classes experienced larger losses. It’s crucial to remember that, even if the income yield in percentage terms on these asset classes remains consistent (which they mostly don’t), the actual income received by the retiree in £ is still affected by the large capital drawdown.
- Over-weighing high-yield asset classes invariably increases concentration risk and reduces diversification in the portfolio.
- There is some empirical evidence to suggest that high dividend stocks tend to outperform over the very long term. But this is more likely to be due to value premium (i.e. equities with a low price-to-dividend ratio or frankly low price-to-anything ratio). Fortunately, there are better ways to capture value premium than price-to-dividends. Using price-to-earning or price-to-book is a far more effective way to achieve this. (See How Not to Get Fired with Smart Beta Investing)
- The strategy relies heavily on the ability of the manager(s) to select high-yield stocks, bonds, property, before the fact, consistently over the very long retirement period. Good luck with that one.
The implication of all this is that a natural yield approach is a bonkers retirement income strategy for virtually all but very wealthy retirees, who mostly rely on other sources of steady income.
Want more in-depth research-based insight on retirement income? Join us at the Science of Retirement Conference on the 1st of March, 2017.