Natural yield strategy has become bad for your wealth

We explain why in light of the dividend drought that has emerged over the past couple of months the 'natural yield' strategy for retirement income is losing its appeal. 

Income drawdown investors face a perennial dilemma as to how much they can safely draw from their pension pot without eroding the capital. For decades the answer has been simply to take the natural income generated by the underlying investments.

But following the global dividend drought that has emerged over the past couple of months as businesses have responded to the coronavirus crisis, the strategy is losing its appeal.

Dividend cuts have seen capital values fall – in some cases notably. As a result, fund managers with an income mandate have struggled to protect capital, particularly those investing solely in the UK. Since the start of the year (to 9 June), the average fund in the UK equity income sector is down 17.6%. However, in contrast, global equity income funds have fared much better, with the average fund showing a loss of 4.4%.

Abraham Okusanya, a chartered financial planner and chartered wealth manager who has written extensively on why the natural yield strategy is unsuitable for retirees (including a book titled Beyond The 4% Rule), explains: “A natural yield retirement income approach fails you at the exact point you need it to hold up — in severe market conditions.”

As a result, the problem is twofold. Yields on income funds will decline, with the historic yield figure based on the past 12 months no longer reflecting reality. At the same time, capital will have shrunk in value. Both problems are exacerbated when, following a decline, capital is drawn to maintain the required level of income. This makes it much harder for the fund subsequently to recover back to its original value – a phenomenon known as pound-cost ravaging.

Yet despite these drawbacks, which were evident prior to the dividend drought, Okusanya notes that various investment professionals view natural yield as a superior strategy for retirement income. The stance, he adds, has been a puzzle in academic research for many years. 

He adds: “Here’s the lesson: company boards don’t give a monkey’s about your retirement income. Dividend is a capital allocation decision. It shouldn’t matter to an investor whether return on equity investments is via capital growth or dividends.”

The same sentiment is echoed by Matthew Yeates, senior investment manager at Seven Investment Management. Yeates notes that the sharp dividend cuts expected in the UK and globally this year have blown apart the theory of relying on natural income in retirement.

He says the strategy is now at an end. “Globally, dividends are being cut heavily this year, and bond yields in the UK are also in negative territory. Anyone relying purely on dividends and bond coupons for income is now facing a big problem,” he adds.

“Assets that pay an income (e.g. when a stock pays a dividend) drop by the value of that dividend on the day that payment is made – so therefore the capital isn’t left intact at all. People often don’t realise this, simply because the size of the individual drop is so small.”

The solution to the problem of reliance on dividend and interest, and one that is more relevant than ever given the headwinds facing markets, is to stop splitting up capital growth and income, adds Yeates.

“Investors looking for a portfolio that maximises their chance of meeting their retirement spending needs should not view income assets and capital growth assets as separate things. It’s better to focus on the total return of portfolios. After all, income can be created by selling the proceeds of capital growth just as easily as from ‘natural’ dividend payments.” Bear in mind, however, that there will be trading costs in the sale of units or shares.

There are other faults with focusing purely in income, including the danger of being exposed to companies and bonds with high yields, which may ultimately prove to be unsustainable.

Tom Allsup, portfolio manager at wealth manager James Hambro & Partners, notes: “Limiting your investments only to companies with high income yields can risk sacrificing both the capital growth and the income. High yields are often a warning flag signalling that the income won’t be paid and, where that happens, capital erosion often follows behind.”

In addition, the investment universe is narrowed, which in turn increases concentration risk, as well as resulting in a lack of exposure to the world’s fastest-growing companies that do not pay dividends: Facebook, Amazon, Alphabet and Netflix.

Okusanya concludes: “A natural yield portfolio that excludes these companies misses out on potential growth. Since dividend payment is a capital allocation decision, one reason these companies don’t pay dividends is that they can deploy capital better than hand it back to investors.

“Excluding these companies from your portfolio increases portfolio concentration at the very least. At worst, it reduces potential return in the long term.”