Natural income or total return? Over recent months we have had a number of discussions with advisers on this question as they consider what is best for their clients at retirement i.e. should they have a strategy which focuses on total return or generating income.

    In reality, we all know it is much more blurred than this, with certain income-oriented stocks also having growth potential, and many total return focused strategies often being underpinned by stable streams of dividends/coupons from their underlying holdings. Nevertheless, it is an important matter to consider. In this article we set out some key considerations and discuss the reasons we believe the greater diversification and predictability offered by a total return approach, is an appropriate way for investors dealing with the challenges of decumulation.

    Setting the definitions

    For the purpose of this article, we define the following:

    Natural Income - where the portfolio’s naturally generated income, whether it be from dividends, interest or coupons, is the source of retirement income.

    Total-return – where the portfolio’s focus is on generating total return from either income or capital and regular withdrawals are made from the investor’s asset pot to pay for their retirement.

    Understand the challenges of natural income

    Undoubtably, using natural income to fund retirement has a number of supporting arguments, including:

    • Income being paid out as it is received. This means there is no need to sell units at potentially unfortunate times i.e. using natural income should reduce the risk of pound cost “ravaging”, an often-cited risk for decumulation, or face the risk of high dealing spreads at the point of sales.
    • Dividends have also, historically, tended to be relatively resilient, as companies seek to manage both pay-out ratios (i.e. proportion of earnings paid out) and balance sheet reserves to achieve this. The chart below sets out companies’ dividend behaviour between February and August this year. As shown, despite all the uncertainty of COVID-19, many companies, most notable in US and Japan actually grew their dividend.

    However, there are a number of important aspects that must be considered when it comes to relying on natural income as the primary source of retirement income.

    Yield is not the same as income

    Higher yielding is often viewed as being attractive, however the phrase 'yield' is often interchanged for 'income' and they are not the same! Income paid out is real money. Yield has many definitions but by far the most common is the ratio of income divided by price. This means that a stock’s yield can go up due to income going up and/or price going down. The former is obviously good for investors, but the latter is not.  In an ideal world, what investors really want is for a stocks’ income to grow and for this growth to be matched by compensatory growth (or more) in the capital price.

    It is this fundamental relationship between income and yield that investors must understand and must challenge any of their income oriented managers on e.g. 'how much capital gain could I be giving up for the yield you say I will get'.

    Current market yields are low, and uncertainty persists

    The current low yield levels give natural income reliant investors the dilemma of accepting a lower level of income or moving into higher yielding stocks/asset classes or starting to redeem capital (i.e. effectively become a total return investor).

    Accepting a lower income could be viewed as the prudent thing to do, as it avoids the need to redeem assets; however, while it may be easy to write in an article such as this, the reality is much more challenging. Investors have fixed costs to be meet and the scope to accept lower income for a sustained period may not exist in reality.

    Equity investors seeking to increase yield may be tempted into higher yielding sectors. However, this must be a considered approach as it has the potential to increase investors’ risk, by potentially focusing in specific asset classes and sectors, potentially at the sacrifice of total returns. The table below shows two of the currently highest and lowest yielding UK sectors. It also shows the performance of these sectors relative to the FTSE All Share over the 12 months to 30 September 2020. As a result of chasing yield, based on the numbers below, there is a risk that investors are overexposed to historically more volatile sectors such as the oil and gas and financials and away from more growth-oriented sectors, such as technology.

    Although we highlighted the resilience of dividends earlier, they are not all immune to the current market challenges, with a number of companies either suspending or reducing their dividends e.g. BP, Shell, Intercontinental and Barclays. Investors relying on these companies will have suffered a hit on the income they receive. This reiterates our belief that, to reduce volatility and give investors greater predictability of investment returns, strategies should be diverse and be designed using robust scenario and stress testing.

    Giving up the eighth wonder of the world

    Einstein was cited as saying compounding was the 'eighth wonder of the world'. This is supported in the chart below, which compares how much £100 invested in the FTSE All Share in 1985 is worth had the dividends been reinvested (orange line), relative to had they been taken (blue line). As shown, based on returns to 30 October 2020, the impact of reinvesting the dividends has resulted in a pot size that is over 3.5 times large.

    Making divestments from across an investor’s portfolio, rather than taking it purely from their dividend paying stocks, potentially offers scope for a greater degree of compounding to take place and therefore is expected to enhance returns over the long-term. For example, the table below compares two strategies, one that makes regular withdrawals of 3% of the initial investment per annum since December 2010, and the other that has taken the reported yield, rather than withdrawal, over the same period.  

    Regular withdrawal Natural yield
    Initial investments (31/12/10) £100,000 £100,000
    Scale of income taken £3,000 p.a., i.e. 3% of initial investment, taken monthly Running yield, taken monthly
    Estimated amount of income over the period £29,750 £38,840
    Residual pot (at 30/11/2020) £132,840 £121,850

    Source datastream. Assumes investment in 50% UK equity and 50% UK gilts, rebalanced on an annual basis, income paid monthly.

    As shown in this example, for the investor that makes the 3% regular withdrawal, although the income is c£9,000 lower over the period, the residual pot is around £11,000 larger, therefore the investor is, in aggregate £2,000 better off.  We appreciate there are a number of assumptions in this example, but it illustrates the power of gaining additional returns from compounding.


    It is the challenges outlined in this article that make us favour a total return approach to decumulation, rather than one that focuses solely on high levels of yield.    

    Our total return emphasis allows us to build portfolios that, as well as having a strong income generating element, also seek to generate capital growth. These portfolios are diversified by asset class (often spread over multiple asset classes), sectors, implementation approach and managers, all of which reduces a number of the concentration risks associated with natural income investing and dilutes the risk of adverse timing of the divestments. The use of regular withdrawals also supports the rebalancing process and reduces transaction costs, all of which are expected to improve long-term customer outcomes. The total return approach also gives investors greater predictability of the amount and timings of monies which will be received, all of which helps support their financial planning and investment needs.

    William Marshall

    Partner, Hymans Robertson

    Risk warning: This communication has been approved and issued by Hymans Robertson LLP (HR) on behalf of Hymans Robertson Investment Services LLP (HRIS) and is based upon their understanding of events as at date of publication. It is designed to be a general summary of topical investments issues, it does not constitute investment advice and is not specific to the circumstances of any particular financial advisory firm. Please note where reference is made to legal matters, HRIS is not qualified to provide legal opinions and you may wish to seek independent legal advice. HRIS accepts no liability for errors or omissions.

    Please note the value of investments, and income from them, may fall as well as rise. This includes equities, government or corporate bonds, and property, whether held directly or in a pooled or collective investment vehicle. Further, investments in developing or emerging markets may be more volatile or less marketable than in mature markets. Exchange rates may also affect the value of an overseas investment. As a result, an investor may not get back the amount originally invested. Past performance is not necessarily a guide to future performance.