A frequent question from investors is “What is a reasonable level of income to expect from my investments bearing in mind inflation?” It has never been an easy one to answer because all predictions of future market behaviour are necessarily uncertain, even over the medium/long term.
Recent academic research has thrown additional light on the topic and it may be a good time to restate our view which we use to guide clients on a day-to-day basis and which has generally served them well. The research is focused mainly on the appropriate expectations for large pension funds and charity endowment portfolios, but they face the same need to produce income for the long term, whether to pay their pensioners or fund their charitable work, as private investors who need income from their capital to live on and who need to be confident that the capital that they have can be relied upon to continue to provide that income even in the face of higher inflation expectations.
The research (Source: Newton Investment Management) is based on “balanced” portfolios split 40% UK equity, 40% overseas equity and 20% bonds. Long-run real returns, in excess of inflation, have been 5.2%, 5.0% and 1.5% respectively giving a weighted-average of 4.4%. These figures take no account of investment costs, which are inevitable in the real world, of perhaps 1%. That suggests that “withdrawal” rates of much over 3% are likely to result in depreciation of capital in real terms.
These long-run figures also ignore shorter term factors such as market volatility which drags on performance as well as the question of whether the analysis starts from “average” market levels; a recent flash of inspiration on the part of a commentator broke the news that it is better to buy low and sell high!
The adverse effect of volatility on returns leads to the inclusion of a significant proportion of bonds in most portfolios, beyond what may be needed for short-term emergencies, as they are generally less volatile than equities. Reducing or eliminating the bond element would clearly be expected to enhance long-term returns towards 5% on the figures above, but at the same time will increase the problem of volatility.
A possible solution to this problem that we propound is greater emphasis on dividend income which is much less volatile, both short- and long-term, than capital values. If investment is in higher-dividend equities so that all or nearly all the “withdrawals” are covered by dividends it may be possible to adopt the higher-equity approach in order to achieve higher total returns.
One must of course address the question of whether higher-income equity is likely to produce lower total returns than the market average but there is no evidence of this; indeed what little evidence there is suggests the reverse, although this is not guaranteed.
On a similar basis is the vexed question of whether active investment management produces better returns after the additional costs than passive, all the above figures being based on market averages and therefore passive. Most of the comparative studies use averages of the results produced by so-called active managers which include many that are “closet trackers” with extra charges. We believe that the active approach may improve results so the expected returns should be higher than those given above.
There is also the broader question of investment risk to consider. Conventional risk analysis looks mainly at capital and total-return volatility as the measure of risk but that seems a flawed approach where the actual capital value of the fund from time to time is largely immaterial: it is its income production that is important.
Another element of the investment universe not brought into the above analysis is the impact of what are now termed “alternatives”, largely because they are so disparate that they are not readily susceptible to academic analysis. Commercial property is the main exception and it has often been included in the composition of long-term portfolios but to a modest extent such as 5-10%. As the long-run return is close to equity at about 4.3% and a large part of that return is in the form of income it readily fits into our theory. Other smaller sectors can also be added on similar grounds.
CONCLUSION
Although not guaranteed, a portfolio constructed on the lines set out above where a reasonable maximum rate of “withdrawal”, consistent with maintaining both capital and income in real terms, is 4% pa provided:
- The investor is prepared to accept greater capital value fluctuation if capital is not being drawn down to fund the withdrawals.
- Care is taken not to “buy high”. One can never be certain of this but an example of a market that appears high now is fixed-interest bonds of all kinds.