It is natural for retirees to focus on yield or the income return from their investment portfolio. A yield is a simple barometer for how much cash you have for living expenses after all.
But with yields at an all-time low (bank deposits are returning 0.70% at the moment), and no rate hikes forecast for the foreseeable future, retirees need to rethink how they are going to earn enough income to meet their spending goals.
Income vs Total Return
A natural yield or income comes in the form of dividends and interest. A capital return comes from the growth of assets over time. For example, the yield on a portfolio might be 3% while the capital return might be 5% in any given year. In this case, we would say the Total Return for your portfolio is 8%.
Many retirees focus solely on the 3% yield though. Why? Well, for many investors, the decision to retire means reaching a savings target—a level where you believe you can earn a decent income owing to a healthy yield. Many retirees target an average yield of 4%.
And if you spend a majority of your career focused on this ‘savings target,’ then once you retire, it can be difficult to pay yourself an amount from your portfolio that may result in your balance dropping below your savings target. You start eating away at your principal in other words.
Understandably, many retirees gravitate towards an income-focused approach to avoid dipping into their principal. There are some drawbacks when you do this that we want to highlight though.
Not What You Expected
In a low-yield environment: a typical income-focused investor has three broad choices:
- Spend less
- Reallocate their portfolio to higher-yielding investments
- Spend from Total Returns instead of income alone
The preference for option two is rooted in a belief that by spending only your portfolio’s yield, you can preserve capital and stand a smaller chance of running out of money in retirement.
But choosing to go overweight on income-producing assets may put your capital at risk. Higher-yielding assets have no correlation with higher capital returns, and you can expose your portfolio to higher ‘concentration risk’. For example, dividend-focused portfolios tend to overweight bank shares.
Chasing Australian share franking credits (particularly for non-taxpaying investors) can also lead you to overlook International shares.
We advocate maintaining a healthy level of diversification and looking at the bigger picture when it comes to the income conundrum. Taking account of all pieces of the pie means considering your individual goals and risk tolerance and focusing on Total Return investing.
Total Return Benefits
Building a portfolio based on Total Return, in contrast with a simple yield, has several advantages. Three main benefits include:
- Staying aligned with your financial goals and risk tolerance
- Having the right mix of assets, plus
- Having more control over the size and timing of withdrawals for income
By looking beyond yield you are also giving yourself more time to realise the value of compound interest from capital returns.
A Total Return Way of Thinking
To sum up, a Total Return approach will help support your spending needs without elevating your risk profile and provide appropriate diversification.
Your portfolio’s overall longevity (higher chance of continued capital growth) will increase as well.
If you’d like to discuss Total Return investing and how it relates to your investment portfolio, then please feel free to speak with an Adviser from Muirfield on (03) 5224 2700.