Not since the Bronze Age have borrowing costs been so low, according to a study published last month.
It’s not surprising then, that investors are becoming increasingly concerned over how best to draw a reasonable level of income from their invested assets and exactly what level of income might be sustainable in the longer term.
This article takes a brief look at the three main strategies that can be used to meet a client’s income requirements.
1. Natural Income Strategy
‘Natural Income’ is simply the dividend and interest payments generated from an investment portfolio. To see how much natural income a typical portfolio might provide, imagine we invested 55% in the index of large UK companies with the remainder in the benchmark 10-year gilt and rebalanced those weights each year. The table below illustrates the yields for each of these assets as well as the aggregated portfolio yield.
|Changing natural income yields|
|Index of large UK companies dividend yield||3.7%||3.7%||3.9%||3.3%||3.8%|
|10-year gilt redemption yield||4.8%||3.9%||1.9%||2.2%||1.2%|
What we see is a high level of variation in the income produced by the portfolio, and this is over a relatively short period of time. From a high of 4.2% in 2008 to a low of 2.6% presently, our hypothetical portfolio has seen a reduction in the stream of natural income of nearly forty percent.
The natural income approach provides a variable income which, depending on market conditions, can fall to disappointing low levels. This is not ideal when clients have specific income requirements.
2. Targeted Income Strategy
The ‘targeted income’ approach aims for a stable rate of income by varying the asset allocation in response to fluctuations in dividend and interest rates. Immediately we run into a problem: the future is uncertain. We simply don’t know what the level of income will be from any particular asset in advance, so it’s difficult to know precisely what our asset allocation ought to be. As a result, this approach can be a little hit and miss and it’s wise to build in a margin of safety.
To illustrate a point, let’s look at the asset split required to keep the yield stable at, for example, 3.8% p.a.
|Changing asset allocation|
|Index of large UK companies exposure||90%||50%||95%||100%||100%|
|10-year gilt exposure||10%||50%||5%||0%||0%|
This table shows the variation in asset allocation required to keep the yield stable; we swing from a 50/50 split to 100% index of large UK companies exposure. It also shows that in one of those years, 2014, we were unable to achieve our target through any combination of the two assets. This illustrates a fundamental problem. Investors seeking a targeted income will be faced with varying risks and sometimes those risks might be outside their bounds of acceptability.
3. Total Return Strategy
The ‘total return’ approach combines a portfolio’s natural income stream with payments from the portfolio’s capital, if required, to provide a fixed income to investors. In employing this approach, investors can maintain a diversified asset allocation and they can control the level and timing of any income they receive. That begs the question ‘what is a sustainable level of income? How can we gauge whether the level of income an investor is drawing is sustainable?
Let’s take an example. Charity A requires a real income of £60,000 per annum, for a period of 20 years and has a basket of investments valued at £1,000,000 allocated in line with the index of large UK companies APCIMS Income Index.
We need to estimate risk and return characteristics for Charity A’s portfolio. Looking at the make-up of assets, we estimate the annual expected rate of return to be 6.9% with an associated annual standard deviation (risk) of 9.5%.
The table presents the results, for a range of income levels starting at £30,000 and rising to £100,000 per annum.
|Probability of Ruin: 20 years per £1,000,000|
|Probability of ‘ruin’||1%||2%||4%||8%||14%||20%||28%||35%|
The table suggests that the probability of ‘ruin’ for Charity A, drawing a real income starting at £60,000 per annum over a period of 20 years is 8%. In other words there is an 8% chance that the portfolio will fail to sustain the targeted income level for the full 20 years. This may or may not be a ‘sustainable’ level in the trustees’ view. As such they may then decide that a different level of income would be more appropriate for their portfolio.
In somewhat typical fashion we have avoided answering the question; what is a sustainable level of income? The answer, of course, depends. It depends on a host of assumptions and that brings with it a great deal of uncertainty. Ultimately, how best to provide an income and at what level hinges on circumstance. In that scenario there’s no substitute for good professional judgement.
The Next Step
If you would like to discuss our thoughts on investment strategies please give the team a call on 01462 687337 or email email@example.com.
This blog first appeared as an article in Light Blue Law, The Cambridge and District Law Society Newsletter
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