Generating a reliable income is crucial for many investors. However, the crisis has made it even more difficult to focus on an effective strategy, and avoid the many dangers – such as striving for yield at all costs – which could affect your long-term income.
Many of us are familiar with the long-term damage that inflation can do to cash – with £100,000 slumping to £82,299 in purchasing power between the end of 2007 and the end of 2018 (source: Bloomberg, Netwealth).
So much for the safety of cash. Cash savers are losing money in real terms every year due to the effects of inflation – and these effects are even more destructive when interest rates and savings account returns are at record lows.
With 42% of total estimated dividends for the current financial year already cut1, there is no longer enough income available to meet the needs of most investors.
Many of these companies are previously dependable heavyweights such as Barclays, HSBC and Lloyds – with the value of FTSE dividends cancelled as a result of the coronavirus reaching at least £26.5 billion so far2, with further cuts expected in the coming months.
Even in normal times portfolios designed purely for income focus on a narrow set of opportunities – there are only so many stocks and bonds whose dividends and coupons are attractive and predictable enough for an income manager. The risk is that income funds become too concentrated in similar assets and may miss out on better returns elsewhere.
While relying on income from single stocks is highly uncertain at present, those that do have secure dividends – for now – can often be overvalued as a result. Investing at a premium can make even the most reliable businesses a risk.
In addition, as portfolio managers struggle to identify alternative sources of income in the current environment, some are taking on additional risk in an attempt to meet yield targets and exposing investors to progressively higher risk companies.
This trend to taking on more risk pre-empts the coronavirus crisis – witness the Woodford scandal – but can be especially damaging for income seekers now as viable options constrict and the security of cash becomes a false safety net.
Further, when the capital value of an income producing asset falls, your capital is essentially paid out as income. For portfolios subject to tax, this can be highly inefficient, particularly for higher and additional rate taxpayers for whom income tax rates are well above capital gains.
Unless you are extremely frugal or very wealthy the old adage of spending your income and leaving your capital invested just doesn’t stack up anymore. Aiming for yield at all costs can lead to much more risk than you might think. Not all bonds, for example, can be assumed as a safe income haven – at the trough this year USD high yield was down 21% (Source: Bloomberg).
While we don’t necessarily see the picture for dividends brightening in the near future, there remain alternative strategies to consider. A sensibly constructed portfolio targeting total returns – including capital gains and dividend income over a given period – can focus on areas of value and embedding protection, rather than solely targeting high yields. Such portfolios blend returns from global stock markets and bonds to provide smoother returns over time while cashflows are drawn from the combined investment pot.
This can spread your risk while generating better total returns as we can see from the period between December 2015 to May 2020, where the Vanguard FTSE All Share Index Unit Trust outperformed the iShares UK Dividend ETF by 33.13%, or 7.61% annualised, despite dividend yields being 2.05% lower on average over the period (Source: Bloomberg, Netwealth).
By focusing on a long-term, blended investment strategy, prioritising ‘time in’ the market as opposed to ‘timing the market’, investors can better protect themselves from the uncertainty of today while continuing to plan for their future goals.
Smarter technology, such as what we have at Netwealth, enables clients to design a personally tailored cashflow strategy with ease, funded from different portfolio components. This provides the opportunity to match payment requirements precisely, driven from a portfolio's total return rather than relying on a narrow set of income-based assets.
Please remember that when investing your capital is at risk.
Large and sustained capital withdrawals can deplete a portfolio over time and you may get back less than you invested.