A 2024 Retirement Income Solution — Part 2
Key Takeaways
Investors typically use dividend paying stocks, or REITs to generate an income to match their spending directly to the portfolio’s yield.
Doing so skews the portfolio to a concentrated market segment and magnifies losses during times of market stress.
A total-return approach strategy has advantages compared to the traditional income seeking approach — broader diversification, reduced volatility, and better control over the quantum and timing of portfolio withdrawals.
Retirement is wonderful if you have two essentials — much to live on and much to live for.
— Unknown
In our previous article, we highlighted the recent changes in the CPF following the 2024 budget announcement and how those changes likely stem from Government’s concern about the retirement adequacy of Singaporeans.
We also broke down the common instruments used by investors to create a retirement or income generation solution:
Higher yielding cash instruments such as fixed deposits, treasury-bills and money market funds.
Government and/or corporate bonds.
Dividend stocks and REITs.
Total-return income portfolio.
Previously, we talked about the pros and cons of (1) and (2). In this article, we want to look at dividend stocks and REITs, and the total-return income approach.
Dividend Stocks and REITs
It is common for investors to look to high dividend payers and REITs as an alternative to income. They try to match their spending is directly to the portfolio’s yield, to avoid employing a more complex investment strategy. However, this type of strategy is “ok” at best. Why? By skewing your investments toward higher-yielding assets and away from broadly diversified asset classes, losses become magnified during times of market stress.
But why does this skew magnify losses? One of the reasons is concentration risk. Take the example below which shows the Morningstar Dividend Yield Index — comprising of stocks with both attractive dividend yields and strong financial quality. The average dividend yield is over 3.6% per annum. When comparing the high yield investment vs a broad index, you will see that it over allocates (selectively overweighs) to certain sectors due to its yield seeking nature. For instance, it has a large overweight to the energy, consumer defensive, healthcare, and utilities sectors.
You may think that these small differences may not have a large impact. However, over the long term, the opportunity cost can be huge. For instance, the difference in performance between global stocks and the high dividend yield approach in the example shown below is approximately +38% over the past 5 years. So no matter how much dividend you may receive, you are likely to still be lagging behind a properly diversified global basket of stocks, and by quite a substantial margin.
Another issue with dividend stocks is that the company can cut or stop dividends due to cashflow problems. We saw this recently during the 2020 pandemic, when earnings took a hit and companies had to drastically scale back dividends in order to preserve cash. Companies can also cut dividends when their business is affected through market cycles and other factors. The diagram below shows that whilst most companies were affected during the 2020 pandemic, others such as Disney and Boeing have cut their dividends recently because of other issues. So if you rely on the dividends as income, you get less whenever these problems occur.
REITs are another investor favourite, for serving as a proxy to owning actual real estate and its ability to provide high yields. However, REITs have a very close correlation to the equity market, with high volatility and sell-offs which mirror the equity market — very unlike actual physical real estate with slower moves due to its illiquidity. In addition, the real estate market as a sector to the overall economy and investment universe is very narrow.
Above is the breakdown of the sector composition of the various large regions. It is important to note that real estate generally makes up only 2% or less of what can be invested in most countries — with the exception of Pacific ex Japan which hovers around 9.5%. However, even in the latter, it is still a very small segment of the market. Having the bulk of your assets in REITs means that you are, by its inherent limitations, concentrating your wealth in a small area of the market. While it may end up working out most of the time, you want to be aware that this is akin to putting all your eggs in one basket.
Total Return Income Portfolio
The total-return approach is what we use to build the GYC Pension Payout Portfolio for our clients. It generates income from capital gains in addition to portfolio yield. So instead of starting with a yield target or a dividend % number, a total-return approach starts from determining how much you need and your comfort level of risk during a market downturn. These factors in turn inform the appropriate asset allocation, which then leads to what is deemed to be sustainable in terms of what the portfolio can pay out.
This strategy has a few key advantages compared to the traditional income seeking approach:
Portfolio diversification
Total-return strategies are much more diversified across asset classes. This allows an investor to capture returns from all sectors and countries around the world instead of being narrowly focused.Reduced volatility
These portfolios tend to be less volatile, have a lower value at risk (VaR) and hold up better during stock market shocks. Additionally, it will also hold up better when encountering specific market risks — for e.g. the recent interest rate rising environment.Better control over the quantum and timing of portfolio withdrawals
With a total-return strategy, investors are likely to have more peace of mind because they can spend from capital gains in addition to portfolio yield. Contrast this to the traditional approach where you are subject to the specific amount and period of when the companies choose to payout the dividend. Furthermore, during an economic downturn, dividends can be cut or withheld, which is exactly what we have seen happen in recent times.
An illustration is shown below for comparison
The Total Return Income Portfolio strategy is contrasted to the traditional (and we believe, outdated) approach of relying on dividends and coupons to sustain your living expense or provide an income. Sure, in a normal or decent market situation, things will likely turn out fine — however, as per the disadvantages we have highlighted earlier in this and last week’s article — such coupons and dividends tend to get affected when companies are not doing well, and as such can be unreliable. A focus on yield also skews portfolio risk too much in a handful of sectors which makes the investment portfolio less robust.
That being said, there is no one-size-fits-all solution when it comes to managing finances. Whether you are best served receiving income from traditional sources, or whether you would be better off reallocating to a total income approach, really depends on your current life situation and needs. We are happy to discuss which approach is better for you and to check whether you are on the right track. Click here to have a chat with us.
