Portfolio Dilemma: what yield should I target?

Mike asks:I have been investing for growth for many years and am finally approaching a point where I can consider retiring.  

I have a sizeable amount invested in pensions and an ISA but am new to the idea of income investing. What level of yield should I be targeting? 

Investment income can be a great way to fund a comfortable retirement. 

But assessing the yields on offer can be a tricky game, whether you are looking at individual shares, equity income funds or other asset classes such as bonds. 

As is often the case in this series, your individual circumstances and preferences will provide a better answer than any broad rule of thumb. 

Firstly, anyone approaching retirement should ask how much money they will expect to need over the coming decades, and ideally carry out cash flow planning. 

This exercise involves you mapping out your future income versus your expected outgoings over the course of retirement. 

While not an exact science, it can give a sense of how much money you might need from a portfolio. 

Cash requirements can often be higher in the earlier years of retirement before falling, and then potentially rising back up later in life because of factors such as potential care costs. 

This is an area where individuals can often benefit from consulting a financial adviser. 

Once you know how much you need, you can see how much money your portfolio might need to generate as a percentage. 

To go with some very easy maths, an individual lucky enough to have a £1 million investment portfolio could get £40,000 a year by generating a 4% yield. 

However a few other considerations are worth weighing up. 

You might also want your portfolio to generate some growth, so as to keep up with inflation. 

The same thinking applies to dividend growth, given that you ideally want your income to keep up with rising costs. 

A starting point 

That immediately brings us to a handful of potential options. 

The recent sell-off in bonds means that yields again look interesting, with a UK 10-year government bond currently yielding north of 5%.  

That would be a “safe” investment for those who simply hold it to maturity and keep collecting the interest payments, though said payments would not increase over time. 

Similarly cash-like funds such as Royal London Short Term Money Mkt Y Inc (B3P2RZ5) can see the returns they generate rise in line with interest rates, giving you some level of income while avoiding substantial investment risks. 

Those who do want to see increases in their pay out will often turn to the equity market, and UK large-cap shares do command a following thanks to their dividend records. 

In the fund space many investment trusts have lengthy records of dividend increases, with the so-called “dividend heroes” including City of London Ord (LSE:CTY), Bankers Ord (LSE:BNKR), Alliance Witan Ord (LSE:ALW), Caledonia Investments Ord (LSE:CLDN), The Global Smaller Companies Trust Ord (LSE:GSCT), F&C Investment Trust Ord (LSE:FCIT) and Brunner Ord (LSE:BUT). 

However not all so-called heroes have such high yields, with names like Scottish Mortgage Ord (LSE:SMT) (on a 0.3% yield) on the list.

It’s therefore worth asking if the yield seems sufficient in the first place. 

Judging yield itself 

The UK market is awash with juicy dividend yields, even after recent price gains have pushed some of these down.  

An individual picking investments based on yield alone might be tempted by names like Ithaca Energy  Ordinary Share (LSE:ITH), on around 9%, Legal & General Group (LSE:LGEN) on 7.4% or Imperial Brands (LSE:IMB) on 6.6%.  

The investment trust sector, which has been under quite some pressure in recent years, can go even further on this front. 

NextEnergy Solar Ord (LSE:NESF) yields 16.5%, for one. 

But here comes the health warning: yields, which move inversely prices, can point to trouble if they are especially high. 

One very broad rule of thumb is that any yield of 7% or more should invite questions. 

Ask, for example, whether the dividend seems sustainable. Is the company or trust facing trouble, and is the dividend actually sustainable?  

NextEnergy Solar, for one, actually slashed its dividend pay out earlier this year and is looking to prioritise a reduction of portfolio debt after multiple challenging years.  

It can therefore make sense to scour a high-yielding company’s results and disclosures to see see if it faces problems, and to check metrics like dividend cover. 

Generally a dividend cover ratio of 2 or higher is consider a reassuring level. 

As ever, diversification can be your friend here. 

An investor with income requirements would do well to diversify, by equity region but also by asset class and by yield level. 

Similarly, it could make sense to hold some growth funds alongside those names more focused on yield. 

While some investors are happy with this, it can also make sense to ask whether you are sacrificing better total returns for a chunky dividend payout. 

That’s a conundrum we have often discussed when it comes to the popular investment trust Henderson Far East Income Ord (LSE:HFEL). 

The trust’s yield tends to sit at, or just below, the 10% level. 

But it has lagged the competition by total returns in recent years, meaning shareholders are certainly sacrificing greater gains elsewhere, for now.