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Why you might care for income
Many retirees and their advisers place emphasis on income from their investments. Others ignore income completely. Is there a right or wrong answer to the importance of income in retirement?
DEFINING INCOME
Let’s start with clarifying what “income” means. Retirees typically use “income” to mean one of two things:
(i) Accounting income from their investment portfolio. This includes dividends from equities, coupon payments from fixed income investments, rental income and interest. It does not include capital gains, whether realised or unrealised.
(ii) Regular payments from their superannuation once they have retired. The source of these payments is not important. “Behind the scenes” you may argue these payments are sourced from accounting income, capital gains or a return of capital.
For the remainder of this article, we will use the first definition, where “income” means income as opposed to capital gains. We will refer to the second definition as “pension payments” to avoid confusion.
Having defined “income” we can rephrase the original question slightly. Should retirees care whether their investment returns are coming from capital gains or from income?
The argument against caring about income
The argument against caring is straight forward. It is total returns that matter for retirees, so why should they care whether those returns are generated by capital gains or by income? Surely a total return of 8% made up of 2% income and 6% capital gains is better than 4% income and 2% capital gains?
This is a powerful argument and large parts of the industry rely on it. In fact, almost all large superannuation funds don’t even distinguish between income and capital gains when they report their returns. For retirees and their advisers who are comfortable with this way of thinking, we would be reluctant to force change. This is especially true for retirees with most of their superannuation in a large superannuation fund. Trying to distinguish between income and capital gains for these investors will only cause confusion.
SMSFS AND ASSETS OUTSIDE SUPERANNUATION
So, if thinking about income may not be helpful for retirees in large superannuation funds, who might find it helpful? We think there are two groups where a focus on income may provide benefits.
The first is self-managed super funds (SMSFs) in pension mode. Retirees using SMSFs have more control over their investments and can easily see whether their investment returns are being driven by capital gains or by income.
The second is retirees with significant assets outside superannuation. This may be anything from investment property, to listed shares to exchange traded funds (ETFs) to managed funds.
MENTAL ACCOUNTING AND MARKET VOLATILITY
We, along with many others in the industry, believe that most new retirees need to keep a healthy exposure to growth assets because most new retirees still have 20 to 30 years of investing ahead. Unfortunately, growth assets are usually more volatile, and that leaves retirees exposed to sudden market falls. Sudden market falls can lead to panicked investors, just itching to sell their investments. Or they can cause investors to worry that their superannuation will run out much sooner than expected.
This is where the idea of “income” can be powerful, particularly for growth assets. Provided an equity or growth portfolio is well diversified, its income is likely to be surprisingly stable. To demonstrate this, take a simple portfolio split equally between Australian equities and global equities, with no rebalancing – just “buy-and-hold”.
The chart below shows the historic income from dividends that this portfolio would have generated. All numbers have been adjusted for inflation, so they represent “real income”. The opening balance is $1 million in today’s terms (equivalent to just over $300,000 in 1983).
Over this 35-year period, this simple equity portfolio shows steadily rising dividend income. Certainly there are periods where dividends contract. Most notable was the global financial crisis (GFC) where dividends of close to $120,000 on this portfolio fell to just over $80,000.
However, compare this variability in income with variability in price. The second chart shows one-year price returns for the Australian and Global components of the portfolio. This is the kind of intimidating volatility investors associate with equity or growth investing.
Encouraging retirees to focus on income, especially dividend income, allows them to mentally quarantine their pension needs from shorter term price volatility. We believe it helps investors hold steady during market sell-offs.
INVESTMENT BENEFITS OF INCOME
But there is a second reason for focusing on investment income, and particularly dividend income from equities. A number of research datasets suggest that companies with higher dividend yields tend to outperform over the very long term. High dividend yield investing is not for everyone; it involves accepting significant style biases in a portfolio. Investing for dividend yield may have a good very long-term track record, but shorter performance has been much more mixed, with extended periods of both market outperformance and underperformance.
The table above summarises findings from three datasets covering high equity yield strategies for US and global equities.
While it may be true that total return should count more than income, it is not true that focusing on income automatically comes at the expense of total return. In fact, the very long-term historic data suggests the opposite.
CONCLUSION
We believe SMSF investors who focus on income are better able to mentally quarantine price volatility in their growth assets from their regular pension requirements. That makes it easier for a retiree and their adviser to buy and then hold onto growth assets in their portfolio.
This mental quarantine is helpful regardless of style biases within the portfolio. However, for investors willing to take a very long-term view, there is evidence to suggest higher dividend yield companies tend to outperformance over the very long term.
Jonathan Shead is head of investments at State Street Global Advisors.
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