In this week’s Perspectives, fund manager David Jane shares a flavour of some recent conversations with financial advisers about natural income and explains how it works in practice.
As more and more advisers become attracted to using natural income for their retiree clients, we are increasingly getting questions about how it works in practice. Therefore, I thought it worth sharing a flavour of some recent discussions. I have written before about pre-retirement planning, and the danger of modelling the past to predict the future. But what is the real-world experience of using natural income pre-retirement? It is something my colleagues and I think about a lot. We have had many conversations with advisers on the practicalities of such an approach.
One of the most positive learnings from this exercise, for me, has been the realisation of just how helpful this can be for the advice process too. When transitioning from a growth strategy to an income strategy ahead of retirement, an adviser’s conversation with clients quickly moves on from the capital value of a client’s portfolios to the income generating capacity.
How might retirement income work in practice?
If a portfolio is transitioned to income-producing using income units, the total income generated can easily be seen on the valuation. During pre-retirement this income won’t be required, so on a regular basis further income producing assets can be bought. Hence, each year the client can see an increase in their portfolio’s income. This may be even greater if they are making contributions.
This strikes me as a much more positive conversation than the conventional approach, where the client sees a total portfolio value, that may be higher but is occasionally lower. In those circumstances, the client has no tangible evidence to understand how close to their goal they may be. As pointed out by one adviser I talked to recently, many clients looking forward to retiring may not have the confidence that they are in a position to retire. By following this strategy, the adviser can give the client the evidence needed to help them pursue their desires.
Income life-styling: a case study example
A simple hypothetical example can show the power of income life-styling. For illustrative purposes only, imagine a portfolio of £100,000, yielding 5%. Assume the income on this portfolio grows naturally at 3%. The client is pre-retirement and reinvesting the income.
In the first year his income is £5,000. By the fifth year he is receiving £6,900 per annum, even with no contributions (assuming no change in the unit price). Obviously, the client in these circumstances is very likely to be making contributions. The longer the period of pre-retirement that the transition to an income strategy takes place, the greater the power of the income compounding the client experiences. The significant proportion of the return from equities comes from reinvested income. The chart below shows the MSCI World Index price only chart vs the total return chart with dividends reinvested.
MSCI World Index price only vs total return with dividends reinvested
Source: Bloomberg 23.09.2024 – 18.09.2024. Past performance is not a reliable indicator of future returns.
Naturally, the overall outcome the client achieves will depend on the total return of the overall portfolio. No-one can predict the future total returns from a portfolio with any accuracy, but the real benefit of using natural income is the fact you are basing your strategy on something more immediately tangible.
You know the level of income a portfolio is generating now. Making guesses of future total returns, whether based on past experience or future predictions, seems to me far riskier than the solid foundation of a known fact: the portfolio’s ability to generate the required income.