Perspectives – are income strategies more risky?

For information purposes only. The views and opinions expressed here are those of the author at the time of writing and can change; they may not represent the views of Premier Miton and should not be taken as statements of fact, nor should they be relied upon for making investment decisions.

A common misconception of income strategies is that they are somehow more risky than total return strategies. This appears to be a result of some significant historic failures of particular strategies but is not evidenced by the broader data. This is an important consideration for investors in drawdown, especially for the majority who are drawing more than the natural income from their portfolio.

We have repeatedly argued that the key risk for investors in retirement is sequencing risk. The impact of large falls in capital values, when a portfolio is in drawdown, can be very significant. Losses at any point in retirement will materially reduce how long the portfolio lasts. Losses are locked in by the need to be continually selling assets to fund income needs. This can be mitigated by only drawing the natural income, but this is simply not possible for the vast majority of retirees. The effect on the capital value of the retirement pot is the opposite of the pound cost averaging that is so beneficial during the accumulation phase.

It follows that mitigating the impact of market falls is a key objective of post-retirement planning. Many advisers hold between one and three years’ spending needs as cash, which does reduce overall portfolio risk, but has a significant negative impact on expected returns. Where the client is drawing heavily from the portfolio, the impact on expected returns and the life of the portfolio can be very material from this strategy. Holding cash reduces both upside risk and downside risk proportionally.

When considering funds or other investment products, not only is expected total return relevant, but the pattern of returns is equally important. A highly volatile strategy may be appropriate in accumulation, where weakness provides opportunity to invest at lower prices, but in retirement it might be inappropriate. In particular, downside volatility is especially important for post retirees.

The Sortino ratio is a measure of returns proportionate to downside risk or volatility. While the Sharpe ratio can measure return for a unit of volatility, the Sortino ignores upside volatility, which is obviously a good thing and considers downside volatility. Higher Sortino implies better downside protection, the key to a long and successful post-retirement investing journey.

This is where income strategies can come into their own. While investors are attracted to high returns, in drawdown this is not the whole story. When units are being encashed on a regular basis, Sortino ratio is at least as important. Well run income and value strategies are the majority of funds with positive Sortino ratios, e.g. better upside participation than downside in the IA 20-60% shares sector.

A simpler but equally important measure in this context is maximum drawdown. This only measures downside risk at a single point in time rather than over the whole journey. It does, however, provide a shortcut to seeing which funds are more suitable for a post retiree in drawdown.

People’s opinion of income strategies has been clouded by the impact of the Global Financial Crisis (GFC) where banks, in particular, did very badly. In most historic drawdowns, income and value strategies have been defensive.

The chart shows the MSCI World Value Index (blue) and MSCI World Growth Index (orange). In the three recent drawdowns value did marginally worse in the GFC but otherwise has proven defensive.

Source: Bloomberg Finance L.P and MSCI –  31/05/1994 – 21/05/2024

In conclusion, post-retirement advice is not only more complicated on the planning side but, on the investment selection front, additional metrics should also be considered, particularly for those clients who need to encash units over time. We would suggest using income strategies can be a good way of addressing this as many have been shown to have lower downside risk over time.

 

David Jane

Premier Miton Macro Thematic Multi Asset Team

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Risks

The value of stock market investments will fluctuate, which will cause fund prices to fall as well as rise and investors may not get back the original amount invested.

Forecasts are not reliable indicators of future returns.

IMPORTANT INFORMATION:

For Investment Professionals only. No other persons should rely on the information contained within.

Whilst every effort has been made to ensure the accuracy of the information provided, we regret that we cannot accept responsibility for any omissions or errors.

The views and opinions expressed here are those of the author at the time of writing and can change; they may not represent the views of Premier Miton and should not be taken as statements of fact, nor should they be relied upon for making investment decisions.

Source: MSCI. Neither MSCI nor any other party involved in or related to compiling, computing or creating the MSCI data makes any express or implied warranties or representations with respect to such data (or the results to be obtained by the use thereof), and all such parties hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability or fitness for a particular purpose with respect to any of such data. Without limiting any of the foregoing, in no event shall MSCI, any of its affiliates or any third party involved in or related to compiling, computing or creating the data have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of the possibility of such damages. No further distribution or dissemination of the MSCI data is permitted without MSCI’s express written consent.

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Issued by Premier Portfolio Managers Limited. (registered in England no. 01235867), authorised and regulated by the Financial Conduct Authority, a member of the Premier Miton Investors marketing group and a subsidiary of Premier Miton Group plc (registered in England no. 06306664). Registered office: Eastgate Court, High Street, Guildford, Surrey GU1 3DE.

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