Thinking about asset classes in terms of income volatility instead of price volatility creates a better starting point for constructing retirement income portfolios, according to analysis by fund manager Legg Mason Global Asset Management.
Individuals in accumulation phase tend to focus on volatility in prices; for individuals in retirement or decumulation phase the more important issue is volatility of income, the manager says. Reece Birtles, chief investment officer for Legg Mason subsidiary Martin Currie Australia, says investors and advisers should therefore understand the volatility of the dollar income – as opposed to the percentage yield – produced by different asset classes.
Birtles says Legg Mason’s analysis suggests investors can be well served by allocating funds to traditional fixed income assets, income-producing equities and assets such as Australian real estate investment trusts (AREITS) and infrastructure, which produce real (inflation-plus) rates of return – a departure from the traditional allocation of 70 per cent to cash and fixed income and 30 per cent to equities, and from the use of annuities.
By allocating dynamically across the three areas, Birtles says investors can achieve a higher and more stable income stream than from term deposits. The Legg Mason analysis reveals that over the past 12 years, income volatility of term deposits has been about 21 per cent while income volatility of dividends has been about 10 per cent.
“To measure income volatility, we’re saying what is the percentage change in this year’s income versus last year’s?” Birtles says.
“[It’s] the same as when you look at share price volatility: how much has the share price gone up and down?
“Clearly, term deposits were producing around $7 of income per $100 [invested] in around 2009, when they had that 7 per cent term deposit yield. Today it’s 2.5 per cent. So the range of how much income has been produced off the term deposit has actually moved in a very wide range.”
Only one down period
Birtles says that over the past 15 years income from an S&P/ASX 200 portfolio of shares has “only had one down period”.
“Dividends were reduced during the global financial crisis,” he says.
“That’s the worst period Australia has had for dividends, basically ever. That’s because, for example, the banks had to recapitalise and did those rights issues, and that diluted some of the dividend-paying power of the Australian market.
“But even despite that worst period ever for Australian dividends, they have shown less volatility than volatility in income [from term deposits].”
Birtles says that constructing portfolios in this manner required advisers to understand that there are three parts to the story.
“There’s capital value, there’s percentage yield, and there’s dollar income,” he says.
“There are actually three elements. So different asset classes can adjust to recalibrate to a new environment based on moving each of those components differently.
“[In shares]…the actual dollar income is quite stable, so when expectations change in terms of what is the required return on shares, the share price adjusts rapidly to reflect the new prospects for growth or risk.
“Whereas in term deposits, capital value can’t adjust, so the percentage yield adjusts and the dollar income adjusts. It’s a matter of what’s important? Is it the volatility in the capital value, or the volatility in income stream?
“What we say doesn’t matter is the percentage yield. There is quite high variability in the percentage yield on dividends over time, because the dollar income is stable [but] share prices move around, so the yield moves.”
A different approach
The Legg Mason analysis offers an alternative approach to addressing investors’ needs in retirement, and follows the launch of an alliance between Colonial First State and the South African financial services company Sanlam to offer funds into the Australian market, featuring a risk-management overlay provided by Milliman. In this case, the aim is to encourage investors to remain as heavily invested in equities as possible, to enjoy the potential benefits of capital growth, while removing some of the volatility traditionally associated with equities.
Birtles says that Legg Mason has “clearly gone in the opposite direction”.
“We’re saying, rather than use our equity income strategy only, and then put derivatives protection on it, we’ve said it’s better to go to this multi-asset-class solution of looking at cash, fixed income, real assets and equity income,” he says.
Birtles says that an overlay strategy “is an alternative”.
“You can do this multi-asset approach and choose the right assets, or you can use derivatives protection,” he says.
“To me, finance theory will tell you it’s better to choose the right assets.”
