The goal of many investors is to build a portfolio that can generate sufficient income to replace traditional sources, but this isn’t as straightforward as it may seem.
It is essential to understand the different methods of extracting money from your investments. How money is withdrawn can dramatically affect the length of time until that pot of money is exhausted.
Broadly speaking there are two opposing camps on how to do this: the “natural income” method and “decumulation”. Here we explain the pros and cons of each.
What is natural income?
This involves taking the cash distributions an investment provides and leaving the capital untouched. For shares, this is dividends; for bank deposits and bonds, it is the interest payments; for property it is the rent received. For example, the benchmark for global stockmarkets (the “MSCI World Index”) was yielding 2.4% on 30 April 2018. Notionally, this would result in £100,000 paying £2,400 in natural income. (Past yield performance is not a guide to future yield performance).
What are the benefits?
The biggest advantage is that your initial investment is left untouched. Its value will of course fluctuate depending on market prices, but you won’t be eating into your capital by having to sell a portion of your investments.
For retirees this is an important consideration. In many countries, longevity - the length of time we live in retirement - is increasing as retirement ages haven’t kept up with escalating life expectancy. If you sell down your capital to harvest income, there’s a danger you can outlive your investments.
Obviously the more units of your investment you sell the quicker the capital amount falls to zero.
As well as not eating away at your capital you get some level of mitigation against inflation - the enemy of every income investor.
As prices rise, the more income you need to maintain the same quality of life. Those keeping cash in the bank will see the purchasing power of their deposits weaken when deposit rates lag price increases, as has been the case in many western economies over the last decade.
However, some asset prices tend to rise in line with inflation, namely shares and property. This means the real value of your investment stands a better chance against the corroding effect of inflation.
But what are the drawbacks of natural income?
Despite the benefits of capital preservation, natural income comes with some drawbacks.
Those requiring consistent levels of income will struggle when the underlying yield of their portfolio changes. The day-to-day headache of having a fluctuating income when trying to budget spending may be too much. Even if the yield percentage stays flat, when the value of the investment changes the amount of money you receive will also change.
The chart below shows how volatile the natural yield method can be over a 30-year period. The portfolio consists of 50% equities and 50% bonds which are rebalanced annually to maintain that split. We applied the Barclays Equity Gilt Study which has 115 years of market returns data.
You can clearly see that the natural income method suffers from volatility. However in the UK it is worth noting that most fund platforms now offer cash accounts for all income generated from your investments to be paid into first before being distributed, allowing you to smooth out some of the ebbs and flows that can be associated with these natural income strategies.
But volatility is not the only challenge - a natural yield may be inadequate to meet income needs.
If an investment yields 3%, a significant amount of money is needed to be invested in order to provide an income amount high enough to live off, for instance.
Can I just sell parts of my portfolio when I need the cash?
Another approach is to reinvest any cash distributions you receive, but then sell down units as and when you require income. This is called “decumulation”. Here you get the significant benefits of compounding, plus the flexibility of being able to take cash when it suits.
The biggest threat to this strategy relates to the timing of when you sell your investments. If you’re relying on the portfolio for income then it is likely you will not have any choice on when you sell. Sell in market lulls and you will be taking out a bigger chunk of your portfolio than during better performing periods. Should this happen repeatedly, your nest egg can quickly dry up. The investment industry calls this “dollar-cost ravaging”.
The chart below shows the consequences of dollar-cost ravaging. Imagine being 65 and having a pot of £100,000 and you withdraw £750 month until the pot depletes to zero. For this illustration we have assumed your investment earns 7% a year on average. However, markets rarely provide smooth returns, some years are better than others.
Each line represents a different path to achieving this average of 7% over the course of the investment, which is shown in the return sequence box.
As you can see, if you get lucky and the market is kind in your first couple of years, your pot lasts until you nearly hit 90 years old. Get unlucky in those early days and you run out of cash at 83.
The takeaway is that should you sell your initial capital investment, you amplify the impact of the market’s volatility. However, the benefit is you can take a steady income stream, making budgeting and spending far easier (while it lasts).
So what should I do, take the natural income or sell down capital? Clearly both have significant advantages and disadvantages. The most appropriate income strategy is more nuanced than simply picking one or the other.
Income fund managers will aim to provide the benefits of both while negating the drawbacks. Some will use financial instruments to try and do this. This involves sharing the upside of a certain investment for a premium, the idea being that your investment may not increase as much when markets rally, but when markets fall it doesn’t decrease as much. The aim of these strategies is to deliver the consistency of the decumulation approach alongside the capital protection of the natural income approach.
With an array of options, it is important investors do their homework, and where necessary, seek professional advice so that they can embark on an investment journey that suits them.
It is also important to note that local tax regimes, individual objectives and risk tolerances should be taken into consideration when deciding upon an appropriate strategy.