Take a total return focus during covid-19

The recent bear market for Australian shares, triggered by the coronavirus pandemic, is the first since Australia emerged from the GFC a decade ago. The uncertainty created was compounded by the swift nature of the sell-down, reaching ‘bear’ territory (defined as a 20% fall in share prices) in less than one month. The GFC took nine months to reach the same unwelcome milestone.

The Australian Prudential Regulation Authority (APRA) announcement—asking banks to defer decisions on dividend payments and suggesting that payouts be at ‘materially’ reduced levels—has further compounded investor uncertainty. However, it need not be the case.

Need to modify income-oriented focus 

The banks are likely to experience materially lower appetite for consumers to borrow and rising bad and doubtful debts in both the residential and commercial sectors. A reduction in bank dividend payments could shore up their capital position and strengthen their ability to weather the economic impact of this pandemic. Such an action may even be in the long-term interests of not just the financial system, but shareholders as well. A company’s financial health is critical to future share price performance.

However, the prevalence of ‘income-oriented’ investing to support the spending needs of retirees means a dividend reduction will leave many in limbo about what to do with their portfolios.

An income-oriented approach involves constructing portfolios of investments that have high income returns that either meet or exceed one’s spending needs. These include shares that pay healthy dividends, especially with franking credits attached, and high-interest bond and cash products.

Targeting income can also have intuitive appeal because it suggests that, by only spending the income generated, the underlying assets are not touched. In theory, the strategy should last forever, or at least outlast a retirement.

Yet, a high-income return is not the only, or even the most effective, strategy to follow. The changes to dividend imputation rules proposed by the Australian Labor Party in 2018 highlighted a potential risk in a concentrated, high-income portfolio. The current market conditions underscores another.

Using capital when necessary

Keeping these risks in mind, an investor might ask: How do I choose a retirement income strategy that will support my lifestyle but not create an over-reliance on income such as dividends?

The answer lies in looking at all sources of return from a portfolio, both income and capital, commonly termed a ‘total-return’ approach.

So what exactly is a total-return approach?

Rather than tying a spending goal only to the income generated on a portfolio, a total-return approach first assesses an individual's or household’s goals and risk tolerance. It then sets the asset allocation at a level that can sustainably support the spending required to meet those goals.

Where an income-oriented strategy utilises returns as income and preserves capital, the total-return approach encourages the use of capital when necessary.

During periods where the income yield of a portfolio falls below an investor’s spending needs, the capital value of the portfolio can be spent to make up the shortfall. As long as the total return drawn from the portfolio doesn’t exceed the sustainable spending rate over the long term, this approach can smooth out spending during the volatile periods for markets. Of course, it may also require the discipline to reinvest a portion of the income during periods where the income generated by the portfolio is higher than the sustainable spending rate.

While capital returns—best represented by the price movement of shares—can be a volatile component of this strategy, taking a long-term view is paramount.

This approach allows investors to separate the spending strategy that best suits their goals in retirement from their portfolio strategy and smooth spending throughout retirement. It allows investors to better diversify risk across countries, sectors and securities rather than skewing the portfolio to a segment of the market with higher-income yields, or worse, taking excessive risk by reaching for the desired yield.

The riskier approach is often a far less reliable response to achieving retirement goals compared to other levers such as saving more or adjusting discretionary spending.

In retirement, the investment horizon can still be long term

By taking a long-term view, investors can also ride out periods like the current crisis with more confidence. Even in retirement, an investor’s time horizon can still be several decades. History has shown this has been sufficient time for the equity risk premium to win through. While dividend yields may reduce, market falls may increase the long-term return prospects for capital values. And this is the crucial reason why APRA’s advice to banks need not be the cause of more uncertainty during an already-challenging time, even for income-oriented investors.

Finally, as this can be an uncomfortable position for many, a further action to improve long-term portfolio prospects is to be aware of the inherent uncertainty in trying to time markets, and the potential improvement in returns that comes from a market sell-off.

In combination, these factors support the merits of rebalancing portfolios during periods of volatility, to ensure they remain well positioned for the eventual turn in the fortunes of the market.