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Misplaced focus on high yielding stocks in retirement

A lot of people seem to view high yielding stocks as the silver bullet for retirement plans. I’m less sure. In many circumstances the focus on income can be flawed, risky and difficult to implement. Return and risk are key to any investment decision.

There are two possible sources of economic return from any asset: income and capital gain. In Australia income and capital gains are taxed differently but this is a non-issue for assets in an account-based pension.

The focus on income has manifested itself lately in equities with the logic being as follows: a high yielding stock, especially one with franked dividends, may be able to meet all the necessary income requirements in the drawdown phase, leaving the capital pool untouched (but importantly variable in value) for uses such as one off discretionary spends, aged care admission, or bequests.

This may well prove the case but it doesn’t mean this is the best retirement investment strategy. There are clear challenges to this line of thinking, real world realities to face up to, and risks to consider.

Challenges to the income-focused model

These days, transaction costs are very low, removing an impediment to realising capital gains to fund retirement spending. Consider the following two scenarios:

  Stock A Stock B
Yield 6% 2%
Change in Price 2% 6%
Total Return 8% 8%

Is there any reason why, if we assume negligible transaction costs, a retiree should prefer Stock A to Stock B? To meet retirement spending requirements, we would account for our income and make a decision of what to do with our capital. From a transaction cost and tax perspective there appears little difference. One may say that it is more convenient to invest in Stock A as the income payment is received and so an active decision to sell down is not required (perhaps there is a behavioural reason why people are hesitant to sell assets in retirement). However, there is a situation where the dividend income may prove too high or the timing (dividends twice per year) doesn’t match our spending plans, requiring an active reinvestment decision (which could also prove to be behaviourally difficult). Capital allocation decisions are largely unavoidable.

Risk cannot be ignored in retirement. Even if a stock generates a high yield, it can still be a volatile stock. One school of thought is that price variability is irrelevant if income levels are secure and high. I find this notion hard to accept, even if someone has very high asset levels.

Consider the case of a retiree with low assets:

  • The yield may not provide sufficient income, or indeed too much income, creating the need to sell down or reinvest. Any need to sell down to meet spending requirement shortfalls breaks the foundations of the income model, which is based on the ability to hold on to the pool of dividend generating stocks

Consider the case of a retiree with high assets:

  • The income from dividends may meet all of the retiree’s spending needs. While there may be some cash left over the reinvestment risk does not critically impact on future retirement cash flow which is assumed to be secured through future dividend payments. However the size of the capital pool to meet discretionary spending and bequests could be highly variable.

Volatility cannot be ignored for low balance retirees (as they will likely need to sell down to meet retirement needs) or for their high balance counterparts (as surely they have some preferences around the size of their account balance which supports one-off spends and bequests). At best, a yield focus is based on some brave assumptions, or less polite, it is a flawed strategy.

Support for income-focused model

There are some investment-based principles which could lend more support to an equity-income focused approach, including:

  • The market, due to the presence of offshore participants, undervalues franking credits
  • Growth strategies, funded by companies reinvesting their equity into opportunities perceived to be unattractive, may not prove successful, and so paying out earnings as dividends is a good strategy
  • The market may have a behavioural bias to overvalue growth (a ‘hope’ bias or a potential thrill of being associated with a successful growth stock) and higher yielding stocks may be undervalued hence attractive.

The above points are views and opinions, not facts; they are highly debated in industry and academia because each one suggests that in some way markets are inefficient. One would need to have strong conviction to use these points as the basis for a retirement strategy.

Retirement drawdown patterns

Retirement strategies cannot be designed without considering real world complexities. The most relevant here is the type of retirement drawdown vehicle. Consider the difference between SMSF’s and the account-based pension products provided by super funds:

  • An SMSF could effectively implement a dividend-yield based retirement strategy, particularly if the SMSF had only one member so that the income level could be targeted appropriately
  • A super fund solution would have multiple leakages. The account-based pension asset pool is subject to constant change (inflows from assets being transitioned from super) and payments (different levels to different members). Super fund products typically run to prescribed cash targets and so much of the dividend payments received would be reinvested

For an SMSF, a dividend yield strategy could be implemented as part of a retirement plan but for a super fund account-based pension solution, there would be much slippage as there are other significant cash flows which would break the path between dividend receipt and member payout. If a super fund account-based pension had a strong focus on equity income, it should really only be based on their market views.

(A post-script to the above paragraph is that if an SMSF implemented such a strategy through investing in a unit trust then they also need to be careful. A unit trust may focus on dividend yield but the distribution to investors can be impacted by other factors such as the flow of funds in and out of the trust.)

If the retirement strategy is built on the foundation of equity income, there needs to be great confidence in the quality and sustainability of that income. If the dividend stream stumbles, the financial plan tumbles: planned income is no longer available and a capital loss would be likely.

Not a silver bullet strategy

In summary, focusing on dividend yield as a retirement strategy can be dangerous. Risk and return are much more important than income in liquid markets with low transaction costs. Focusing on dividend yield alone is flawed as it ignores the preferences of the individual regarding their capital reserves. There are investment-based views as to why high-yielding stocks are attractive, but these are views not facts. SMSF’s can implement a yield-based retirement strategy if they want to, but should be careful with how they implement (directly versus unit trust products), while for the account-based pensions offered by super funds a strategy based on equity yield should only be based on investment views.

 

David Bell is Chief Investment Officer at superannuation fund Mine Super. He is also working towards a PhD at University of NSW. This article is for general education purposes. Individuals should seek financial advice, but challenge their adviser if they recommend a strategy purely based on equity income.

 

3 Comments
Paul from Brisbane
February 11, 2016

As a planner who for over a decade has used the yield in retirement strategy, I disagree wholeheartedly with the inference that focusing on yield in retirement is "dangerous". The biggest danger in retirement is the sell down of "units" of capital to fund everyday living needs. Once sold the return on these units can never be replenished. This is why it's imperative to have (depending on risk profile) 3-4 years of income in cash, any yield shortfall through company based problems or economic slowdown can be topped up with the cash holdings, retaining the full units of investment intact. Have used this for clients through the Dotcom boom/bust, 2001 terrorists attacks, GFC, 2011 market correction and it still tops my preference for strategy. The biggest danger in retirement is having a strategy where your drawdowns are predicated on capital growth. Growth is the one thing you CANNOT rely upon.

Terry Dwyer
August 14, 2015

I am not sure I entirely agree. The nineteenth century approach of never spending capital has a lot to commend it. Dividends are often a sign of future sustainable income whereas capital gains can become capital losses and represent no "commitment" by the company as to what it thinks it will be able to pay you. I would be perfectly indifferent if companies could semi-promise capital gains.

Nick
August 07, 2015

Thanks David. Well done for throwing the spotlight on an important issue.

A lot of the commentary we see in this area implicitly assumes that the retiree's goal to source their income in retirement entirely from income (i.e. with no drawdown from capital), thus leaving the capital untouched and hence as a bequest.

This is the same line of thinking we see in the argument "a retirement account of (say) $500,000 invested in cash at 3% yields $15,000 pa" and then comments on the (lack of) adequacy of that income to meet retiree's needs (even after it is supplemented by the age pension).

In my view this implicit assumption is questionable for all but the highest wealth retirees. With most retirees emerging with low or modest retirement balances, drawing down capital over retirement is essential to reaching any sort of reasonable income, and it is misleading to suggest otherwise.

 

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