Can shares deliver the reliable income stream self-directed investors seek in retirement? John Moore explains how Australian equities can achieve this desired result.
As an increasing number of Australians are approaching or entering retirement, demand is growing for investment solutions that can provide predictable income and more security of capital. However, in the current low interest rate environment, traditionally safe investments, such as bonds and term deposits, potentially can no longer provide enough income to sustain retirement lifestyles. This means many retiree and pre-retiree investors are having to expand their investment horizons and consider shares as a source of retirement income.
An ageing population is increasing the demand for income and capital preservation solutions
During their working life, most people’s priority is to build their wealth. Typically investors take on a higher level of portfolio risk because their retirement is years away and there is time for their savings to recover from periods of market weakness or negative returns.
When nearing, or in retirement, investors’ focus tends to shift away from wealth accumulation and towards maintaining a lifestyle in retirement. Many of these investors realise that if a wealth-destroying event like the global financial crisis (GFC) occurs during or just before retirement, they won’t have the opportunity to recover or indeed top up their savings. As a result, they’re looking for retirement investment strategies that aim to provide them with both reliable income and some capital protection.
Traditional low-risk sources of income are now higher risk and low return
Term deposits and bonds have traditionally been attractive to investors who want a conservative investment strategy and a predictable income stream. During and after the GFC, as risk-averse investors moved out of shares, the safe-haven status of bonds and term deposits attracted significant fund inflows around the globe.
Shifting into term deposits and bonds three or four years ago proved a very rewarding strategy. Until recently, fixed income funds delivered at least high single-digit returns. Loose monetary policies around the globe and the flood of money seeking a safer investment pushed bond yields to historic lows, leading to strong capital gains for bond investors. In Australia, term deposit investors enjoyed high interest rates as banks competed for scarce funding.
However, recent returns from bond strategies and term deposits are likely to be markedly lower. The current yields from fixed income funds are now barely positive after allowing for tax and inflation, and it’s very unlikely bond investors will enjoy capital gains of the scale seen in recent years. In fact, the potential for capital losses is increasing as the global economy continues to improve and central banks, such as the United States Federal Reserve, reduce quantitative easing.
While term deposit investors don’t have to worry about capital loss, they do need to be concerned about low deposit interest rates. Term deposit investors who were enjoying rates of around 4 per cent a year or more three years ago will be lucky to get a rate above 2.5 per cent a year today, unless they are prepared to tie up their money for three to five years.
For term deposit investors, current interest rates are too low to provide enough income for most people to live on or maintain the purchasing power of their savings when inflation is considered.
Australia’s modest economic performance suggests domestic interest rates are unlikely to rise in a hurry. The longer low interest rates persist, the greater the pressure on those who are relying on bonds and term deposits to either curtail their spending or find alternative sources of income. That’s why many investors have been forced to look elsewhere for income and are finding a solution, perhaps unexpectedly, in dividend-paying Australian shares.
The role of Australian shares in an income strategy
In the past few years, a growing number of investors seeking reliable income have increased their exposure to Australian-listed dividend-paying companies. Figure 1 shows the average dividend yield of the 100 largest companies listed on the Australian share market is currently around 4.5 per cent, which is better than most term deposit rates and comparable to bond yields. Add on the after-tax franking benefits and the return increases, especially for retirees. Making a share portfolio work harder to earn extra income
Investing in shares for income obviously works best if company dividends are sustained and grow over the long term. However, dividend growth isn’t guaranteed. There are times, such as during the GFC, when companies are forced to cut their dividends due to difficult trading conditions and falling profits. In those circumstances, dividends alone may not meet an investor’s need for income.
So, if investors intend for their shares to be a source of income, it is important they consider ways of earning income from their shares in addition to dividends and franking credits.
One strategy practised widely in the share market involves a shareholder selling an option contract over shares they own. The buyer of the option pays a premium in return for the right (but not the obligation) to buy or sell the shares at an agreed price on or before a defined date, depending on how they think the share price will move. The extra income the shareholder earns by selling the option is additional to the dividend and franking credits they receive from owning the shares.
For SMSFs, which are generally taxed at a concessional rate of 15 per cent, imputation credits can be valuable. Tax credits are received by the investor on the company tax already paid, effectively increasing the after-tax return. If investors measure their returns on an after-tax basis, the imputation credit can add up to 0.9 per cent extra return for an SMSF on a 15 per cent tax rate. An equity portfolio that explicitly targets imputation credits and income for low tax payers can be managed more effectively than a traditional equity portfolio.
Figure 2 shows the cumulative return impact of franking credits for an SMSF since 2002.
While building a diversified income stream from shares that includes dividends, franking credits and premium income from trading options makes sense, it’s difficult for an individual investor to manage. Companies’ financial characteristics, market conditions and opportunities in the options market are always changing. That’s why many investors prefer to invest in shares through a managed fund in which investment professionals select the investments.
Figure 1: Australia’s top 100 listed companies have healthy dividend yields
Source: Bloomberg, Omega Global Investors
Figure 2: S&P/ASX200 – Cumulative relative return
Source: Omega Global Investors
Balancing income and volatility when investing in shares
Although investing in shares for their dividend and other income flows can be an attractive idea, share prices do fluctuate. Some investors, especially retirees or near-retirees with fresh memories of the GFC, may still be nervous about exposing their capital to the risk of a market fall. So, are there portfolio solutions that combine the income flows available from shares with the potential to limit exposure to market volatility and the risk of capital loss?
Some share funds, called equity income funds, aim to achieve both objectives. These funds typically invest in large, higher-yielding Australian shares for dividend income. They may also use derivatives, such as options and futures, to provide another source of income and reduce some of the capital volatility of shares.
There’s a broad range of equity income funds. Their investment strategies and risk and return profiles vary, so it is important an investor chooses a fund they understand and that has investment objectives consistent with their needs.
What strategies do the professional investors use?
I often am asked the question: so, what do the professional investors do? It’s a great question that starts with strategising to solve the conundrum of delivering investors a regular income, and some potential for capital preservation, all the while seeking to reduce exposure to market volatility. The strategy we deploy aims to generate a tax-effective and regular income stream of 4 per cent to 6 per cent each year (paid quarterly) from owning a well-diversified portfolio of Australian companies. On top of this, we apply an option overlay strategy to help generate additional income and provide some protection from share market falls. By using options, we aim to reduce investors’ share market exposure to around 50 per cent to help preserve some of their capital in weak markets. It’s important to understand the flip side of this approach is that in rising markets our strategy may lag market performance. Importantly, by giving up some upside, the portfolio is also less risky or volatile, limiting the downside when compared to the ASX 200 Australian Share Index.
Investors who need income and want to protect some of their capital when the market is weak could use an equity income strategy like this as the core of their investment portfolio, or blend it with complementary income-orientated strategies.
For the foreseeable future, bonds and term deposits are unlikely to provide most investors with the income they need to fund their lifestyles. As a result, investors’ search for alternative strategies that focus on delivering income has intensified. Equity income funds that have an explicit focus on generating income, and aim to preserve some capital in periods of market weakness, may be an ideal solution.