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Income-focused approach exposing retirees to greater risk: Vanguard

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According to new analysis from the multinational investment group, investor portfolios built on a dividend-focused strategy will need to be fully allocated to equities and escalate their portfolio risk, to meet most income needs in the current low-yield environment.

A recent Vanguard research paper on the total returns approach found that investors using the rule of thumb 4 per cent withdrawal rate as a target for income from their investment returns could have relied on a diversified portfolio of 50 per cent equities and 50 per cent bonds back in 2013. 

However, to obtain the same result today, investors will need to shift to 100 per cent equities and almost double their risk.

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Inna Zorina, senior investment strategist at Vanguard Australia said many retirees who have experienced the recent slash in dividends in the Aussie share market are “understandably worried, given their reliance on these payouts to fund their retirement”. 

“This scenario requires a retired investor, arguably at the most conservative phase of their investment journey, to take on immense risk,” Ms Zorina said. 

”It certainly presents a real challenge to the most impacted group in today’s low-yield and high volatility investing environment, and is probably not in their longer-term best interest.”

The research has also found that contrary to a popular rationale, investing in higher dividend-paying stocks will not necessarily generate greater overall returns relative to other equities.

Vanguard has warned of a risk of tilting a portfolio towards value stocks, finding that the higher yield an equity portfolio delivers, the more substantial the amount of concentration risk the portfolio holds.

“Previously proposed changes to dividend imputation rules highlighted the potential risks that a high-yield, concentrated portfolio may be exposed to. The current high volatility, low yield environment further affirms these risks,” Ms Zorina said.

“The alternative to an income-oriented strategy is the total returns approach, where a portfolio’s asset allocation is set at a level that can sustainably support the spending required to meet those goals and encourages the use of capital returns when necessary.”

This approach, according to Vanguard, will allow for the capital value of the portfolio to be spent during periods where the income yield of a portfolio falls below an investor’s spending needs. 

It is meant to utilise both income and capital growth elements of the portfolio during the volatile periods for markets which inevitably occur, as long as the total amount drawn from the portfolio doesn’t exceed the sustainable spending rate over the long-term.

“While this approach requires the discipline to reinvest a portion of the income yield during periods where the income generated by the portfolio is higher than what is required for living expenses, it provides many advantages over the income-focused method,” said Ms Zorina.

“In addition to helping address unintended factor and credit exposures, this approach also addresses the main concerns that many retirees have around portfolio longevity.

“Ultimately ensuring your portfolio includes an appropriate level of diversification matters for all ages and stages, and certainly even more in retirement. The total returns approach aims to provide for income needs without the risk trade-off.”

 

Income-focused approach exposing retirees to greater risk: Vanguard
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