Using natural income¹ to fund retirement may seem like an obvious approach but it has, historically, been the least often used strategy. With yields now looking more attractive, this may become a more viable option for clients and may help advisers seeking to manage retirement risk, writes BNY Investments head of retirement, Richard Parkin.

Growing interest?

Those not involved in retirement advice often assume, not unreasonably, that because people want income in retirement, income-led investment strategies are the most popular investment approach. In fact, as the chart below and some other 2024 research² shows, they are the least often used by advisers.
 

Conversations with advisers reveal that one of the main reasons for this lack of usage is simply that many income-focused funds have not been able to generate the levels of yield that most clients will want to meet their spending needs.

However, it seems that, with interest rates and yields back to what might be seen as more ‘normal’ levels after 15 years of artificially low rates, income investing in retirement could be set to see a revival. The Financial Conduct Authority’s (FCA’s) recent review of retirement income advice reminded us that we need to consider the specific risks retirees face, including their capacity for loss not just of capital but of income. A portfolio specifically designed and managed to generate a growing income seems an obvious way of meeting this requirement.

A natural fit?

Drawing the natural income from a portfolio has the obvious advantage that it helps to maintain the client’s capital. This means that capital remains available to generate income in future years and to pass on to dependents as inheritance.

Because clients aren’t drawing on capital to fund income payments, they should be less concerned by market volatility of capital, which may provide more flexibility in how they are invested. They also avoid the effects of sequence of returns risk, the risk of negative market returns occurring early in their retirement, that can impact those drawing from capital to support income.

Finally, but very importantly, taking natural income from investments is an intuitively simple idea for clients to understand and knowing they are not drawing on their capital, and that they need not be especially concerned by short-term market falls, can provide valuable peace of mind.

Perceived challenges

Not everyone will be able to or want to live off natural income and some will have to draw on capital to supplement income payments. Ideally, the natural income paid will be enough to meet not just the client’s income needs but also cover adviser and platform costs. However, even if clients need more than natural income alone can deliver, income-led strategies may still be useful. Income focused portfolios can be managed to have inherent characteristics that make them more reliable when drawing on capital. These include potentially lower volatility, lower downside, and faster recovery from market stresses than more growth-oriented funds.

Even where initial income is sufficient to meet client needs, its variability may complicate retirement planning. Funds that focus on maximising yield may find it difficult to maintain nominal income from year-to-year. Also, while companies tend to focus on maintaining and growing dividends, there can be market-wide shocks such as that which occurred at the start of the pandemic in 2020.

Strategies that seek to maximise income may do so at the cost of capital security and growth. This may be done by buying high coupon bonds above par value which generate a loss at maturity. For equities it may involve selling derivatives like call options to generate income but which may curtail gains in rising markets. These approaches may be appropriate for some clients but may be less able to deliver a stable and growing income alongside capital growth.

Another barrier to using natural income for some has been the operational complexity of managing this for clients. Not all platforms are able to simply pay natural income directly and income can sometimes get diverted to pay for fees or be unwittingly used to rebalance portfolios. Some platforms can manage natural income more effectively, however in any case an easier approach is to use the accumulating share class of an income-led fund and meet income payments through selling shares. Provided withdrawals are aligned with the underlying natural income being generated then the overall outcome for clients should be very similar to taking the income.

The ideal income strategy?

So why choose a specific income fund rather than, say, its stablemates with no particular income focus and a similar benchmark? After all, it is likely that both offer income share classes. The answer to this is subtle, especially where both are run by the same team using shared research.

The managers are focused on delivering the right client experience in each case. Clients looking for stable and growing income deserve their needs to be met in just as thoughtful a way as those seeking long term growth. A strategy that is designed and managed to deliver the following characteristics is likely to be more appropriate:

• An attractive yield: The starting level of income should be sufficient to meet the client’s needs and ideally meet any advice and platform costs.
• Income stability and growth: A deliberate focus on ensuring that income is at least stable in cash terms from year to year but preferably grows to help offset inflation and maintain living standards.
• Capital growth: The potential to grow capital to help mitigate future bouts of high inflation, provide increased security, and/or supplement income payments.
• Frequent and consistent of payments: Regular consistent payments of income throughout the year to align with the client’s likely spending patterns.

This may seem like a big ask but it can be delivered. Using an active multi-asset approach can allow a balance to be struck between maintaining and growing income from year to year and growing capital over the medium term. Supplementing investment in equities and fixed income with alternative investments can provide even greater potential to generate income allowing more of the portfolio to be focused on growing capital. Because income is more likely to be stable, advisers will have a stronger guide for the level of withdrawal that can be taken from an accumulating share class through regular encashments if they don’t want the complexity of managing income distributions.

Meeting client and adviser needs

We’ve focused on using natural income as the main source of retirement income but of course it can be used in other ways. For those following a total return approach, multi-asset income funds can demonstrate a consistency of return that can reduce sequence of returns risk. Where advisers are using a bucket approach then the strategy can be deployed in the growth bucket with income being used to top up cash and reduce the need for rebalancing to fund payments to clients.

Where clients have very rigid minimum income requirements, a strategy  with a strong track record of delivering stable income could  be of value and can, of course, be combined with secure income sources such as annuities and bond portfolios to deliver greater income security.

With continuing market uncertainty and with inflation now more variable and impactful than we’ve seen over the past decade, clients are expected to increasingly want stable and growing income. Investing in strategies that are designed and managed to deliver that seems an obvious way of being able to meet that need. We expect that interest in income investing will grow as more advisers appreciate this and recognise that this match of need and product is aligned with recent UK regulatory thinking.

If you would like further information on our capabilities in multi-asset income investing, please click on the below:

The value of investments can fall. Investors may not get back the amount invested. Income from investments may vary and is not guaranteed.

¹Investments in shares and bonds usually pay out income in the form of dividends and interest. This is referred to as their natural income.

²UK Financial Advisers: Advice in Decumulation, Platforum March 2024.