What is the best way to maximise your retirement income?

Generating Income versus taking capital

Investing for retirement is a hugely complex business and potentially fraught with risks. Principle among these risks for savers who are taking an income is ensuring withdrawals are sustainable.

Sustainable will, of course, mean different things to different people. One person might feel comfortable making large withdrawals from their investment fund safe in the knowledge they have a chunky defined-benefit pension to fall back on if it runs out early.

Another, however, might be relying on their pension to live on in retirement and so needs to carefully manage withdrawals, so they don’t run out of pension too quickly.

When deciding how to manage withdrawals, two strategies leap to mind – ‘natural yield’ and ‘total return’. But which delivers the best outcomes? And is there a single ‘right way’ to devise a retirement income strategy?

Natural yield

The theory behind the natural yield approach to investing has been around for generations. Under natural yield rather than selling your investments to fund retirement spending, you simply live off the income these investments produce. This could be dividends if you’re invested in stocks and shares, the coupons paid on bonds or interest on cash.

You can see the inherent attractiveness of this approach. By not selling the underlying investments they can continue to grow and, crucially, you won’t face the prospect of so-called ‘pound cost ravaging’. This is the idea that withdrawals made during falling markets will be more difficult to recover in the future - particularly where investments are sold just as a client enters drawdown.

By living off the natural yield of these investments – and again remember this is just the theory – you give your pot a better chance of riding out any downturns and in the process maximise the chances of making it last throughout retirement. If dividends keep on delivering, you might even have enough left over to pay for exceptional costs (such as long-term care) or to leave to loved ones.

Problems

It is when you get into a practical application that a natural yield approach can, in some circumstances, run into problems. The majority of people will have a set amount they need to spend to fund their day-to-day lifestyles (and any additional luxuries) in retirement.

Let’s assume a 65-year-old has a portfolio worth £500,000 and, after carrying out a full review of her spending priorities, requires a budget for the year of £25,000.

If the portfolio generates a dividend yield of 5% then happy days! That’s £25,000 in the investors pocket, and the underlying capital left entirely untouched.

However, rigidly following a natural yield strategy hits choppy waters when things don’t go so well. What if the same portfolio delivered a yield of just 2%? Is the same investor really going to be able to manage on £10,000 – less than half the budget they originally set out?

Low yields on traditional investments present a challenge for income-focused investors

While historically dividend yields of 5% or more were not uncommon, for many investors it is the low-yield scenario that has been closer to their experience in recent years as bond coupons have hit new lows and the hunt for reliable dividends has become ever more difficult. The FTSE 100 is forecast to yield around 4% in 2017, although after fees you might be looking at a real yield of around 3%.

If this is what plays out, the natural yield won’t be enough to fund their retirement needs.

Furthermore, the yield is by its very nature only a percentage term, and so the actual amount the investor gets will also depend on how the underlying assets perform. So there is volatility (uncertainty of yield) layered on volatility (uncertainty of performance of the underlying funds).

Some will also be tempted to chase yield by upping the risk in their portfolio. While clearly, it is sensible to review investments regularly, the obvious danger in taking extra risk is that performance could go the other way or anticipated dividends fail to materialise.

Total return – the solution?

To generate the required income without taking on unwanted risks, many investors adopt a total return approach to income. As you might expect, this involves combining both the income generated through dividends and coupons with some capital depletion to maximise retirement income.

Investment giant Vanguard points to two principle advantages of a total return approach versus natural yield:

  • Maintains a portfolio’s diversification – by focusing entirely on generating an income, there is a risk the underlying portfolio won’t be as diversified as it could otherwise be. This could mean that overall returns are lower or more volatile under a natural yield approach as a result.

  • Allows more control over the size and timing of portfolio withdrawals – by shifting away from the straightjacket of a natural yield strategy, investors can supplement income from investments by drawing from their capital appreciation to ensure they have enough money to fund their retirement spending needs.

Of course, the extent to which a total return strategy will work depends on the combination of capital returns and dividend yield delivered by the underlying investments. When withdrawing from capital investors will also need to factor in inflation, which is currently running at 2.6% in the UK and a lot more in other countries.

A post-charges capital return of 3%, for example, would equate to the real capital appreciation of just 0.4% - withdrawing any more than this would then eat into the real value of the fund.

Ultimately which of these strategies works best will depend on the individual circumstances. In an ideal world everyone would be able to adopt a natural yield strategy but, in the realms of reality, most will need to dip into their capital at certain points in their retirement

Source: Tom Selby, AJ Bell Invest Centre