Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 264

Redefining risk for income investors

An equity-based investment fund that aims to deliver dependable income is likely to deviate significantly from the Australian share market index. It requires an active approach to manage a set of different risks.

For a typical return-seeking equity fund aiming to outperform the index, the main risk is ‘relative risk’ due to the portfolio deviating from the index and underperforming this benchmark. But what really matters for income investors is the risk that the fund does not deliver a sustainable and growing income stream.

A different set of risks requires a different approach.

Risks specific to the income investor

Income investors face several unique risks that are often not acknowledged in traditional investment literature:

Income level risk

Typically, income investors aim to generate an income stream that enables them to maintain their standard of living. This is a critical issue for retirees, and to achieve this goal they must tackle income level risk – the danger that income paid by an investment falls in response to interest rate changes and other factors.

For example, in 2010 one of Australia’s leading banks offered its customers a five-year term deposit rate of 8% pa. Today, the market rate is below 3.5% pa and around 2% for a more popular 90-day term. For investors who have relied on short-term cash rates, the steady fall in interest rates over this decade has exposed them to heightened income risk. Of course, living costs continue to rise.

In today’s lower interest rate world, term deposit investors need to invest larger sums of capital to achieve the same dollar return. Additionally, these lower rates impact the returns from other annuity-type products and create significant challenges.

Inflation risk

Inflation risk is the risk that the real value of an income stream declines as the cost of living rises. For investors to maintain their spending power and living standards, they must ensure their income stream grows at least in line with inflation. This is particularly important for people in retirement as they are likely to incur increased costs in areas such as health care and aged care services.

For example, investing in a term deposit at 2% pa when inflation is compounding at 2.5% annually leaves the investor with a real (inflation-adjusted) return of negative 0.5%.

Given retirees usually have a relatively fixed capital base, inflation protection is central to any medium- to long-term income-oriented financial plan.

Income volatility risk

Investors worry about movements in the capital value of their investments but for income investors, we believe it is more important to focus on the volatility of the income stream. What matters most for income investors is that their investments deliver a sustainable and growing income stream, and the main risk they face is that it does not. Reducing the volatility of the income stream in search of reliable income delivery should be a primary consideration.

Chart 1: Income volatility over the last 15 years – equities and cash

Past performance is not a guide to future performance.

Source: Martin Currie Australia, Factset; as of 30 June 2018. *Average 'special' rate (all terms).

The chart above compares the volatility of Australian shares (prices and dividends) and term deposit income over the last 15 years. The volatility of the income stream from term deposits is more than double the volatility of the dividend stream from Australian equities, and the income from dividends has been materially higher.

With this understanding, equity income investors are increasingly valuing the more dependable nature of dividend streams especially from higher quality companies and are worrying less about short-term capital volatility associated with share markets.

Asset managers have helped with this process through educating investors on the opportunities and risks of equity-based strategies and by developing specialist funds to enable them to benefit from these attractive income streams.

Longevity risk

Australians are living longer. As the chart below shows, the average life expectancy of Australian men and women is now over 90 years, having increased by around 20 years since 1960. So the probability (risk) of outliving savings is growing, and this is known as longevity risk.

Chart 2: Australian life expectancy (at birth)

Source: Australian Institute of Health and Welfare, Australian Treasury Intergenerational Report, ABS, March 2018

Over the next 40 years, Australia’s population will experience a major shift. A far greater proportion of the population will be older, and the dominant baby boomer generation will move into retirement. This combination will significantly increase the nation’s pension expenses and upset the balance between retirees and the working age people who are funding the pension system. Currently, for every person aged 65 and over there are 4.5 people of workforce age (15 to 64 years) but this is forecast to decrease to around 2.7 people per retiree by 2055, putting an increased strain on the entire system (see the 2015 Intergenerational Report, Chapter 1, Australian Department of Treasury).

This all points towards continued growth in demand for income-generating investment solutions, particularly given the prevailing ‘lower for longer’ view of interest rates. In this world, equities can carry much of the burden, especially funds that utilise proven active management focused on uncovering the highest quality, most sustainable, dividend streams.

The real risk/return trade-off for income investors

Investors seeking income need solutions that can generate a yield high enough to meet their requirements today, that is sustainable over the long term, that can be expected to grow at least in line with inflation, whilst also protecting their hard-earned capital base. This requires a change in investor behaviour and the need to challenge some traditional investment approaches.

Given these specific risks, what is the true risk/return trade-off that applies to income-focused portfolios?

The traditional approach to investing looks at the potential total return (capital plus income) of an investment and compares it to the expected risk. The aim is to create a portfolio that can deliver the best possible return for a given amount of expected risk. But this only makes sense if your investment objective is focused on total return. If you are an income investor, your objective is to generate a sustainable and growing income stream. Hence a different approach to investing and portfolio construction is required as low risk in this context is defined as income sustainability.

Chart 3: Expected income versus income risk

Source: Martin Currie Australia, ASFA, Factset; as of 30 June 2018. Income is calculated using manager assumptions for each asset class – because of this, the returns quoted are estimated figures and are therefore not guaranteed. *Data calculated for representative Legg Mason Martin Currie Australia Equity Income (1), Real Income (2) and Diversified Income (3) accounts in A$ gross of management fee; gross performance data is presented without deducting investment advisory fees, broker commissions, or other expenses that reduce the return to investors. Assumes zero percent tax rate and full franking benefits realised in tax return.

The risk/return chart above examines how the major asset classes fare when the portfolio construction trade-off is redefined as expected income versus income risk (also known as the expected volatility of the income stream).  Term deposits have deeply disappointed as the dramatic drop in interest rates over the past decade means that the volatility of the income offered is high and actually worse than the income volatility from emerging market shares. Australian shares and A-REITs do much better and these can be improved further by dedicated equity income strategies that target the companies that matter most to income investors – those with high dividends that are both sustainable in difficult economic conditions and are expected to increase in value over time.

 

Andy Sowerby is Managing Director at Legg Mason Australia, a sponsor of Cuffelinks. This article is general information and does not consider the circumstances of any investor. The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.

For more articles and papers from Legg Mason, please click here.

4 Comments
Martin Mulcare
July 27, 2018

Thanks, Andy. I wrote a column for "Professional Planner" in August 2014 which pointed out the challenge for financial advisers to adjust their thinking from volatility risk to income risk when working with their clients. Your well-presented argument reminds me that my concern remains.....

Raymond
July 27, 2018

Have been following the strategy of building sustainable & growing income streams derived from the above strategies for about the last 24 years - then getting clients to focus on the low variability in the income being generated (avoids focus on the top line portfolio volatility issue you have identified). Apart from the GFC where there was so much uncertainty about everything, has worked fine!

Of course, I have had to build the equity component of the portfolio from direct shares so as to get the actual cash dividend paid - and the value of the refundable franking credits!

Stan
July 26, 2018

I assume the "bonds" (undefined) you show are some mix of Government,semi-Gov and corporates,thus giving a lower income return than equities for the same income risk. It is possible to construct the bond part of a portfolio using a mix of fixed,floating,indexed,and R.M.B.S. corporate bonds only (maybe with some non-A$ exposure) and achieve the 6-7% shown for your various income strategies without suffering from greater income risk.
The bond component of my S.M.S.F has income of just over 7% (range 3-12 %);removing the 12% outlier would still give 6% with income risk much lower than the typical equities I hold.

Ashley
July 26, 2018

Good reminder that bank deposits are indeed ‘risky’ in that their returns (income) fluctuates (volatility) is more than for shares ! – eg Bank 5 year TD rates dropped by 60%+ from 8% in 2010 to just 3% now – which is a greater fall than share prices and dividends in the GFC and all prior crashes. Not only that, share prices and dividends recover much faster than TD rates.

 

Leave a Comment:

     

RELATED ARTICLES

High or low price, future returns will be low

Best-in-class, ‘pure-play’ companies give clearer focus

Single-period measures do not work for great growth companies

banner

Most viewed in recent weeks

Unexpected results in our retirement income survey

Who knew? With some surprise results, the Government is on unexpected firm ground in asking people to draw on all their assets in retirement, although the comments show what feisty and informed readers we have.

10 reasons wealthy homeowners shouldn't receive welfare

The RBA Governor says rising house prices are due to "the design of our taxation and social security systems". The OECD says "the prolonged boom in house prices has inflated the wealth of many pensioners without impacting their pension eligibility." What's your view?

Three all-time best tables for every adviser and investor

It's a remarkable statistic. In any year since 1875, if you had invested in the Australian stock index, turned away and come back eight years later, your average return would be 120% with no negative periods.

The looming excess of housing and why prices will fall

Never stand between Australian households and an uncapped government programme with $3 billion in ‘free money’ to build or renovate their homes. But excess supply is coming with an absence of net migration.

Five stocks that have worked well in our portfolios

Picking macro trends is difficult. What may seem logical and compelling one minute may completely change a few months later. There are better rewards from focussing on identifying the best companies at good prices.

Six COVID opportunist stocks prospering in adversity

Some high-quality companies have emerged even stronger since the onset of COVID and are well placed for outperformance. We call these the ‘COVID Opportunists’ as they are now dominating their specific sectors.

Latest Updates

Retirement

10 reasons wealthy homeowners shouldn't receive welfare

The RBA Governor says rising house prices are due to "the design of our taxation and social security systems". The OECD says "the prolonged boom in house prices has inflated the wealth of many pensioners without impacting their pension eligibility." What's your view?

Interviews

Sean Fenton on marching to your own investment tune

Is it more difficult to find stocks to short in a rising market? What impact has central bank dominance had over stock selection? How do you combine income and growth in a portfolio? Where are the opportunities?

Compliance

D’oh! DDO rules turn some funds into a punching bag

The Design and Distribution Obligations (DDO) come into effect in two weeks. They will change the way banks promote products, force some small funds to close to new members and push issues into the listed space.

Shares

Dividends, disruption and star performers in FY21 wrap

Company results in FY21 were generally good with some standout results from those thriving in tough conditions. We highlight the companies that delivered some of the best results and our future  expectations.

Fixed interest

Coles no longer happy with the status quo

It used to be Down, Down for prices but the new status quo is Down Down for emissions. Until now, the realm of ESG has been mainly fund managers as 'responsible investors', but companies are now pushing credentials.

Investment strategies

Seven factors driving growth in Managed Accounts

As Managed Accounts surge through $100 billion for the first time, the line between retail, wholesale and institutional capabilities and portfolios continues to blur. Lower costs help with best interest duties.

Retirement

Reader Survey: home values in age pension asset test

Read our article on the family home in the age pension test, with the RBA Governor putting the onus on social security to address house prices and the OECD calling out wealthy pensioners. What is your view?

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.