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  • Writer's pictureNoel Watson

Using a natural income strategy. The natural choice?

Updated: May 9

Introduction


A popular approach for those seeking income in retirement is to purchase a basket of higher-yielding investments and live off the portfolio income. This strategy is known as natural income or natural yield and is often touted by asset managers and financial advisers. At a superficial level, it can seem like a reasonable approach as it eliminates the need to sell down assets and, therefore, the risk of running out of money in retirement.


How does this strategy stack up in the real world, and what should you look out for?



Total return - another option


The total return approach differs from the natural income alternative because it doesn't differentiate between capital growth and portfolio income. It seeks to draw income to satisfy expenditure demands, selling down funds in the portfolio as and when required. Below, we identify four limitations of the typical natural income offerings compared to the total return strategy.



The natural income analysis is often undertaken over a limited period.


We have the good fortune to have over a century of historical market data to evaluate how our retirement planning strategies based on the total return approach may have fared during challenging times. However, as we pointed out in challenge #3 in our analysis of the 4% rule, even this might be considered insufficient, as it only covers around three typical 30-year retirements, and there is always the chance that the future could be worse than we've experienced in our dataset.


However, this is typically far more than the analysis we often see for a natural income approach, which often only goes back 20 years or less. As we pointed out in our recent article on the sequence of returns risk, the challenging market events this century have had much less of an impact on retirement incomes than those we experienced in the 20th century, meaning we'd struggle to determine how a proposed natural income approach might fare during more challenging times.



Elevated concentration risk and lack of diversification (eggs in one basket):


Maximising diversification is one of our investing beliefs that helps drive how we build client portfolios. These portfolios typically hold a mix of asset classes from around the world and often have over 10,000 individual holdings.


In contrast, natural income approaches tend to be based on the following:

  1. Limited geography: U.K. markets only

  2. One asset class: Equities (shares) only

  3. Limited holdings: Sometimes only 10-20 shares or a handful of funds (holding U.K. shares).

  4. Style of holdings: The holdings tend to be (understandably) more focused on those companies paying higher distributions, further reducing diversification.



Too much volatility?


As pointed out in the previous section, a natural income approach is often based on a 100% equity portfolio. We recently looked at 100% equity portfolios in retirement and highlighted the comments of retirement researcher David Blanchett when discussing an approach - "no person that works with real humans would suggest that!"


Below, you can see historical U.K. equity bear markets showing the depth of falls and how long the markets took to recover. This emphasises our point above about analysis conducted over limited periods - how would a client adopting the natural income approach holding a portfolio of U.K. shares/investments have fared during challenging times such as the 1970s? Would they have remained invested as they saw their portfolio plummet?



Those holding a portfolio of investment trusts might suffer from more significant drawdowns. These funds can employ leverage, and their share price can differ from the value of the underlying holdings (Net Asset Value (NAV)). In challenging markets, this can lead to more severe falls than the overall market. Looking back to the market turmoil during the Global Financial Crisis, we can see how the gap between the share price and NAVs increased.


"The financial turmoil of late 2008 saw the size-weighted discount of this sector hit its widest recorded level of 24% on November 25 of that year."


If we look at how a global equity benchmark (MSCI ACWI) fared during COVID, it was down around 22% vs the start of the year.



Compare these falls with some of the bigger (assets over £2bn) investment trusts I took from some research espousing the natural income approach. Here, the falls are often more severe, in some cases almost 40%!



Those holding higher-yield assets also suffered during the pandemic, according to research from Vanguard.




Fluctuating incomes


In our experience, retirees want to be able to shape their retirement income to fit the cost of their desired lifestyle. This might involve, for example, spending more while they are still in good health or making one-off gifts to the children. Of course, they may have to make spending adjustments based on the market returns, but a risk-based guardrails approach based on a total return strategy helps limit downside adjustments. In contrast, with a natural income approach, you are at the mercy of the markets. As Abraham Okusanya points out, income from a portfolio based on 100% shares can dramatically fluctuate when measured in real terms.


"Take for instance, our Class 1900 who started their retirement with a natural income of £4,550. By the second year, their inflation adjusted income fell to £3,897 and by the 5th year it was £3,005. But their troubles were only just beginning; by their 20th year in retirement, their real income yield had fallen to £1,024."


You may hear claims that some natural income-style funds have offered increasing yearly dividends over many decades. However, this often doesn't take inflation into account, and during a period such as the 1970s, when inflation peaked at around 25%, this can hugely erode the purchasing power of this approach.



Conclusion


Once you analyse the data over a meaningful period and evaluate how the natural yield approach fits real-world retiree spending patterns, it's hard to see how such an approach can be considered superior to a total return strategy, especially when used in conjunction with a risk-based guardrails approach.



Want to find out more?


If you would like to know more about designing and implementing a robust withdrawal strategy, please contact us.


About us


The team at Pyrford Financial Planning are highly qualified Independent Financial Advisers based in Weybridge, Surrey. We specialise in retirement planning and provide financial advice on pensions, investments, and inheritance tax.

Our office telephone number is 01932 645150.


Our office address is No 5, The Heights, Weybridge KT13 0NY.


Please note: This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.

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