I spend a lot of my time talking to advisers about retirement income. Those who’ve been in the profession a long time recall the time, before the global financial crisis, when income funds were a key part of client portfolios. How distribution funds were the go-to approach, and the UK Income sector dominated fund flows.
In our recent research, ‘Retirement Advice in the UK: Time for change?’, produced in conjunction with NextWealth, we found that natural income is the least often used approach for clients generating income for retirement.
There are, though, signs that this is changing. While there is no single ‘right’ way for investing in retirement, the case for natural income can be made on regulatory, investment and commercial grounds.
The Financial Conduct Authority’s review of retirement income advice reminded us that, when assessing risk in retirement, we need to consider the client’s capacity for loss in terms of their real income. That is, their ability to withstand a reduction in spending capacity. Income-oriented investment strategies therefore seem like an obvious fit.
Income strategies can and do perform very differently from the broader market
Because income strategies do not require us to sell shares to generate income, the client’s underlying capital remains at work in the real economy to support future income payments so underpinning the durability of income that clients need.
Income strategies such as equity income can and do perform very differently from the broader market, as we have seen in recent years.
When markets retrench from being concentrated in a small number of growth stocks, we often find that income stocks show more resilience thanks to the cover on their dividends, and this means clients see greater stability that’s needed to maintain their income.
This has been apparent over recent weeks as highly valued technology stocks have borne the brunt of inflation and growth worries while more established, dividend paying companies have fared much better.
We can also expect equity income strategies to be useful in providing much-needed protection against inflation surprises. While we will hopefully not be returning to the double-digit inflation we saw in 2022, it’s clear that inflation uncertainty is a key consideration in retirement planning that might span several decades.
We generally expect equities to deliver inflation-beating returns, but equity income strategies may provide a closer match to inflationary patterns.
Established companies with a strong track record of paying dividends tend to be better able to absorb price increases and/or pass them on to customers to maintain revenues and margins and grow dividends.
Where clients rely on total return approaches to support retirement income, that is, selling shares to generate income, advisers will often use a cash buffer.
Having an allocation to cash allows income to be drawn from the buffer in times of market stress so avoiding the need to sell assets at depressed prices and eating further into capital than may be desirable.
Our research shows that 84% of advisers use cash buffers with 30% of advisers allocating three or more years’ worth of income to these buffers.
Strategies that actively manage income can deliver the level and stability of income that clients need
Using natural income does not remove the need for a cash buffer. Clients will always want to have some cash at hand for unexpected expenses. However, an income-led investment strategy should mean we have to hold a much lower amount in cash as we no longer need to worry about eating into capital at depressed market prices.
This means less cash drag. That is, a greater proportion of the client’s assets can remain invested and under advice which should boost returns for clients while simplifying administration and maintaining fees for advisers.
There are, of course, challenges to using natural income. Our research shows that advisers often feel the income generated may not be enough to meet client needs, is too variable and unpredictable, and that administering income can be challenging. These are valid concerns, but they can be overcome.
Strategies that actively manage income can deliver the level and stability of income that clients need. Moreover, payments can be structured in a way that provides the client with a regular predictable income which also simplifies adviser administration by not having to constantly manage tax-wrapper withdrawals.
The income-led approach may not be suitable for all clients, but it offers characteristics that match the client’s need while also supporting advisers’ business models, and we believe it deserves to be enjoying a revival.
Richard Parkin is head of retirement at BNY Investments
