Sustainable Income

Avoiding the Income Squeeze -

The Pitfalls of Total Return Investing in a No Income World

By Peter Cook, CFA, CFP, Senior Investment Writer
December 2019

The Pitfalls of Total Return Investing

In a former life, as a financial planner, I counselled my clients to heed the tenants of Total Return Investing (TRI). Forget about income, I said. Trust the academics, and the professionals (me). Today I believe that Total Return Investing may be doing investors a great disservice. Not out of malice but because the global investment landscape has changed, and so have the risks.

By way of background, Total Return Investing posits that investors should build and learn to live off the total return of their portfolio, not just income. In practice, this entails selling appreciated assets when they need income above what is generated by the portfolio. And, to the extent possible, living off dividend and interest income in the years when the portfolio declines.

The Total Return approach is elegant, it makes intuitive sense, and like so many investment strategies, it backtests well. There is, however, a fly in the ointment. That proverbial fly is the prevailing global low-to-no interest rate regime. Total Return portfolio theory is, to a great degree, underpinned historical backtests in the U.S. which occurred during periods when both stock and bond yields were significantly higher.

5-Year U.S Treasury Yield (1963 - 2019)

Thus, the TRI theory is based on what we now know to be the luxurious presumption of earning income from fixed income. No one has had the experience of funding a 30+ year retirement through a period of zero or even negative interest rates.

The Short Income Squeeze

This lack of income is a critical weakness of TRI theory because the less income your portfolio generates, the more you are exposed to the negative consequences of drawing-down on principal during market-drawdowns - what I term a “Short Income Squeeze Risk”.

Here’s how it works; in the event of a market-downturn, a lack of income creates, what is, in essence, a short-squeeze situation. Retirees have no choice but to sell their investments and often at times when valuations dictate they should be buying or at least holding.

To date, this danger has been easy to ignore because returns have been strong and volatility relatively benign. However, there are reasons to believe it may not be in the future.

The New Risk Hierarchy - Consistency of Income Trumps Portfolio Volatility

Intelligent investors think in terms of risk and then return. So it may be helpful to rephrase the issue in terms of a hierarchy of risk. In the past, the risk of an “Income-Squeeze” could be easily subordinated to the risk of portfolio volatility because income was readily available. Today’s environment calls for a re-assessment of this assumption.

I contend that below a certain portfolio income threshold*, income consistency should take precedence over minimising volatility. Investors and their advisers should examine this new retirement risk landscape and re-calibrate their portfolio’s if necessary.

Sustainable Income – Mitigating Income Squeeze Risk

One strategy to mitigate Income Squeeze risk is to increase the portfolio allocation to investments that hold out the prospect of sustainable dividends. Specifically, companies and credits with stable business models that are wedded to secular growth trends, such as population growth both in Australia and abroad.

The classic rejoinder to such advice is that it entails foolishly “reaching for yield”, i.e. unknowingly increasing risk by moving from lower to higher risk assets. And it is true, increasing your allocation to riskier assets will raise the volatility of your portfolio.

However, the paradoxical world created by low-to-now interest rates means that the income generated by equity-like dividends may come to be the only way to shelter retirees from an Income Squeeze and thereby from having to draw down on principal during a severe or even moderate downturn.

Thus, it can be argued that by taking more risk, you are making the conscious decision to reduce income risk (the income-squeeze). In this context, the choice is not a reach for yield but the inevitable by-product of all investment decisions, the exchange of one type of risk for another.  

Recognising this, Legg Mason has partnered with our clients and affiliates to craft income solutions like the Legg Mason Martin Currie Equity Income and Legg Mason Brandywine Global Income Optimiser which are designed to invest in assets that hold out the prospect of providing sustainable income. As central banks continue to consign investors to a world without income, we believe these strategies will play an increasingly important role in clients’ portfolios. 

 

 

* This threshold will depend on several factors unique to the person or institutions circumstance. These may Include: income relative to portfolio size, spending flexibility and other sources of funds constraints. The degree of capital risk assumed relative to income obtained is also a critical consideration. Consult a financial professional before making any investment decisions.

Past performance is no indication of future performance.

Issued by Legg Mason Asset Management Australia Limited (ABN 76 004 835 849, AFSL 240827) (Legg Mason Australia) which is part of the Legg Mason Inc. group. Any reference to ‘Legg Mason Australia’ or ‘Martin Currie Australia’ is a reference to Legg Mason Asset Management Australia Limited. ‘Martin Currie Australia’ is a division within Legg Mason Asset Management Australia Limited. Legg Mason Australia as Responsible Entity has appointed Martin Currie as the fund manager for Legg Mason Martin Currie Equity Income Fund (ARSN 150 751821. Before making an investment decision you should read the relevant Product Disclosure Statement (PDS) carefully and you need to consider, with or without the assistance of a financial adviser, whether such an investment is appropriate in light of your particular investment needs, objectives and financial circumstances. Legg Mason Australia as Responsible Entity has appointed Brandywine Global as the fund manager for the Legg Mason Brandywine Global Income Optimiser Fund (ARSN 618 213 488). Before making an investment decision you should read the relevant Product Disclosure Statement (PDS) carefully and you need to consider, with or without the assistance of a financial adviser, whether such an investment is appropriate in light of your particular investment needs, objectives and financial circumstances.