Use of income-led strategies

Perhaps surprisingly, income-led strategies are reportedly one of the least used approaches for clients looking to decumulate retirement wealth. In research conducted in November and December 2022 for Aegon¹, advisers were asked which of three approaches they tended to recommend for clients drawing retirement income.

These approaches are:

• Total return approach (ie portfolio designed to deliver returns with income generated through selling units/shares).
• “Bucket” approach (ie portfolio divided between cash, intermediate and growth assets) with income payments typically funded from cash holdings.
•  Income oriented approach (ie portfolio designed to generate natural income with payments possibly supplemented by capital withdrawals from selling units/shares)
   

Figure 1: Use of investment approaches for clients taking retirement income

Source: “Managing Lifetime Wealth: retirement planning in the UK”, Richard Parkin Consulting and Next Wealth for Aegon 2023. Question: “When creating portfolios for clients taking retirement income, how does your firm tend to structure investment portfolios?” (n=212)

A core reason for the limited popularity of income-led strategies was that many felt they could not generate sufficient income for clients without compromising diversification and/or increasing risk. We understand that there are also some operational challenges with paying natural income from platforms, but it is not clear how big an impact this has had.

It’s also worth noting that many advisers use the same set of portfolios for clients decumulating wealth as they use for those accumulating it. In our recent retirement research, Life Beyond Work: The changing face of retirement, we found that only a third of advisers use a different set of portfolios specifically designed for drawdown². It is perhaps not surprising then that income strategies are less favoured than total return strategies that will be the most common approach for clients accumulating wealth.

Potential changes in approach

There are indications that, with interest rates and yields now higher than they have been since the Global Financial Crisis, interest in natural income portfolios for clients in decumulation is increasing.

A starting income of around 4% of savings is often used as a rule of thumb for what might be seen as a sustainable income. However, advisers will also need to cover advice fees and platform fees which together might vary between 0.75% and 1.5%. Advisers might therefore be looking for a starting yield of around 5% after fund costs to use an income-led approach for decumulation clients. This has become more achievable in the current environment.

We expect that the FCA’s thematic review of retirement income advice will put pressure on advisers to demonstrate that the portfolios they use are relevant for retirement income clients and that this may help spur the already rising interest in income-led portfolios.

A recent straw poll of 18 advisers following a webinar we delivered showed that over 75% of them were considering greater use of income-led strategies³, with the remainder equally split between those that said they would never use them and those that already employed them. We are currently working with FT Adviser on some research looking at how advisers invest for decumulation, how that is changing, and whether there is a real trend towards income-led investing in retirement.

Potential benefits of income-led strategies

All other things being equal, whether return is delivered through income or capital gain should be unimportant to an investor. When looking at the sustainability of income, or the eventual growth achieved, the source of return should be irrelevant.

In practice, strategies that generate higher levels of income will tend to have characteristics that may make them more attractive to decumulation investors. If we consider equity income for example, we expect it to have the following characteristics compared to a more growth-oriented equity portfolio:

• Lower volatility: The price of stocks should reflect the discounted value of future cashflows. The price of stocks that have an established income stream should vary less than those where high-income growth is predicted in the future as they will be less sensitive to changes in the discount rate.
• Lower drawdown: For the reasons discussed above, we might reasonably expect income stocks to not fall as far as more growth-oriented stocks in a downturn. This is particularly relevant for clients in decumulation who need to realise capital to generate all or part of their income.
• Quicker recovery: We also observe that income stocks may also recover from a sharp drawdown more quickly than growth-oriented stocks. Again, this may be because their value is more driven by near-term cash flows which may be seen as more reliable than those of growth-oriented stocks where the outlook may be less certain.

As a result of these features we find that equity income portfolios, particularly those managed with a quality and value bias, exhibit superior sequencing-risk characteristics. This means that they could sustain retirement income better than portfolios without those biases irrespective of how income is actually drawn from the fund. There is a behavioural alignment between portfolio manager and invested pensioners: Both are focused on reliable underlying payments streams from high quality sources. These tend to offer resilience in the face of economic and market uncertainty.

Another important feature of equity income strategies is that they seem to do well in times of higher inflation. The chart below shows that for the US market, higher-income stocks have tended to do well against the market in times of higher inflation.

Figure 2: Median 12-month return of sector-neutral dividend factors vs. S&P 500 at different rates of inflation

For illustrative purposes only.

Source: Robert Shiller, Goldman Sachs Global Investment Research, 4 April 2022. Highest dividend yield stocks represent highest quintile.

We are currently looking at whether this is a feature of income stocks in other markets but there is a logic to this in that companies that can support higher dividends are likely to be well-established, mature businesses who may be better able to pass on input cost inflation and so continue to grow profits and dividends in line with inflation. Also, higher inflation will likely be accompanied by higher interest rates which will tend to favour income stocks as detailed above.

Finally, moving away from the investment considerations, advisers may be attracted to income-led strategies for decumulation for a couple of reasons:

• Avoidance of sequence of returns risk: Because clients are not required to sell shares to fund income withdrawals, they can mitigate the impact of sequencing risk where market falls are compounded by withdrawals. This should, in theory, improve sustainability of income.
• Maintenance of capital: Some advisers may prefer to work with clients who are able to maintain capital rather than having to draw it down. Income-led strategies are naturally more likely to keep capital intact.

Challenges of income-led strategies

While the rise in yields has made it easier to build a well-diversified income portfolio while still generating sufficient income for clients, focusing on income generation may be seen as a constraint on portfolio construction to some extent. However, as highlighted above, it can be argued that the strategies that are more appropriate for income-led investment also have characteristics that meet the needs of decumulation investors. In particular, many decumulation investors will be more focused on getting the right balance of risk and reward and avoiding big losses rather than aiming to maximise return which will be the focus of most of those accumulating wealth. This aligns well with the focus of income portfolio managers.

Variability of income will likely be an issue for many and building good income-led portfolios for retirement goes beyond just putting together strategies that have the required yield. Ensuring some stability of income in monetary terms from year-to-year will be important, preferably with income growing to help offset the effects of inflation. Clearly, where a client has a fixed income requirement, advisers will need to have confidence that the portfolio will be able to meet this in most circumstances. They can, of course, supplement income payments with capital withdrawals but no doubt would prefer to avoid this.

An income-led strategy may also increase oversight and administration of the client’s retirement plan. Natural income payments are unlikely, except by chance, to align with client income preference needs. Any additional income requirement must be funded from capital, or any excess income reinvested. Using an accumulation share class however makes this no more effort than selling units in a total return strategy and the reported natural income forms a handy bellwether of the degree to which natural capital is being eroded or rebuilt.

Conclusion

We see income-led strategies as very relevant for clients decumulating wealth. With the recovery in yields, there is significant scope to build portfolios that can support sustainable income. While there may be an additional overhead for advisers in maintaining this approach, it has advantages for clients and advisers that merit the extra effort. We sense that there is already growing interest in income-led strategies and expect the FCA retirement income advice review will spur further interest in this approach. 

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

¹Managing Lifetime Wealth: retirement planning in the UK, NextWealth and Richard Parkin Consulting for Aegon, February 2023

²Source: Research conducted by NMG Consulting for BNY Mellon Investment Management between June and July 2023, based on responses to an online survey with 202 retirement-focused financial advisers

³BNY Mellon Investment Management, October 2023