Income Provision - Case Study
The following is a case study that we thought would be useful to clients and demonstrates how income can be provided in the current low interest rate environment.
Over the last decade it has become increasingly difficult to invest with the sole objective of income; historically those who required an income would be able to invest in a combination of assets including Cash, Gilts, Bonds and Equities to create a portfolio that not only provided diversification but also offered a reasonable level of income.In pre-financial crisis times Cash Deposits were 5% or more (The Bank of England Base Rate was 5.5% in December 2007); 10 Year Gilts and Corporate Bonds yielded over 5% and the FTSE-100 had an average yield of over 3%. The result was that most combinations of these assets would have not only provided a reasonable income but would also prove to offer protection in the Financial Crisis as Gilt and AAA Corporate Bond yields tightened offsetting losses in the equity component of a portfolio.
However, times are now very different as Quantitative Easing and ultra-low interest rates have driven up the value of nearly all assets classes leaving their yield’s and income in most cases very depressed. Cash offers little value to savers as interest rates now lag rising inflation and the value of cash is being eroded. Investors have also become increasingly willing to take on rising levels of risk for diminishing levels of future returns.
You could of course argue that there are shares out there that yield well over 5% and that these are of value for income seekers; it is though, a case of “buyer beware” as the graph in image one that we produced last year shows that FTSE-100 companies are paying out an increasing level of their earnings creating the risk of dividend cuts.
Another interesting feature of this graph is the FTSE-100 in blue and how market tops coincided with peaks in the pay-out ratio. UK Gilts and US Treasuries provide another example of increasing risk and diminishing returns; the graph in image two shows how the yield on 10 Year US Treasuries has been in decline for over 30 years forcing prices upwards.
The yield on 10 Year Gilts is now under 1% and Bank of England Base Rate 0.25%; there is only so much more the BoE can cut interest rates and push up the price of Gilts further – at present there appears much more potential downside to Gilts than upside with inflation also rising. This coupled with the sub 1% interest rates savers face has also led investors to other more esoteric investments that they would perhaps not even consider in normal conditions. Our view has been to approach the problem differently, shunning the traditional approach and looking to an alternative goals based strategy to help clients meet their needs.
Goals Based Strategy
The strategy that we use for clients has been some years in the making; we had traditionally used an approach that often meant that client used a proportion of their capital to provide an income for a set period – the remainder was left invested with the broad objective of replacing the “spent” monies. However, along the way we found whilst we always built in tolerances that ensured we could deal with most changes in client requirements or unexpected events we were not articulating this to client’s. They were typically relieved that we had a plan B (or C, D, E and sometimes F!) but we then started to think that wouldn’t it be better to make it more explicit?
Whilst researching Goal Based Investment I came across J. L. P. Brunel’s book “Goals Based Wealth Management” and lots of the ideas within this were very in much in line with our thinking and objectives. The concepts were intuitive and with some refinement have allowed us to create an approach that we feel works well for the majority of our client’s and means that we do not face the difficulty of attempting to meet a broad objective of providing a set income within a single risk profile.
Research tells us that the vast majority of people do not set themselves goals, whether it be out of fear, lack of know-how or lack of encouragement. Clearly defined goals and objectives are measurable, we can gauge success or failure and make adjustments to get back on the right road.
Following a goal based strategy encompasses Financial, Investment and Tax planning; for this reason, our initial discussions with client’s are often extensive as it is vital that we build a snapshot of financial and family circumstances. Everyone is different, but we can still separate and prioritise objectives into four distinct areas: –
- Needs
- Wants
- Wishes
- Dreams
Depending on age each of these will have different time frames from less than five years to over 30 years or more in some circumstances. Even at this high level, things start to get complex and it’s impossible to have one single strategy that gives the best chance of success; just because a client completes an attitude to risk questionnaire that classifies them as a Balanced investor over a term of 15 years or more it doesn’t mean that this strategy and its volatility suits their near-term objectives.
Our approach is to agree a strategy that suits not only each individual goal and time frame, but also the level of risk a client is willing (and needs) to take to achieve their objective matching it to a clear financial plan and investment portfolio. We undertake detailed cash-flow analysis based on reasonable assumptions to establish for each specific objective: –
- The capital required to meet income or growth targets
- The rate of return required to achieve targets
- The effects of inflation on these target
The Financial Plan creates the overview and provides the details as to what is required to meet each goal, most importantly the required rate of return and time horizon. This does require a little extra work from our clients as we ask them to consider risk for each objective rather than their entire capital. Each objective is then assigned a suitable investment portfolio, with its allocation designed to give the highest probability of success.
We currently have six different investment portfolios that we use to meet client objectives and goals; ranging from Short Term Lifestyle that is typically used to provide income in the early years and will have a high cash weighting to Long Term Growth that is more equity orientated.
When we make our recommendation we look at ensuring a strategy is sustainable over a twenty-year time frame, and if possible repeatable for a further twenty years. For example, a client has £150,000 to invest and requires additional income of £9,600 for two years and £5,500 thereafter. In this case we split the capital into four separate segments, as you can see in image three.
In this image we have accepted that the first component Income 2020-2022 will undoubtedly fall in value as capital is withdrawn; to a lesser extent that will also happen to 2023-2027 funds but this at least will have a chance to grow before withdrawals commence.
These two segments are matched to Short Term Lifestyle and Long Term Lifestyle Portfolios whose asset mix has historically outperformed the client’s Internal Rate of Return that is needed to achieve to meet our target end value.
Meanwhile Income 2028-2037 has over 10 years before income is needed and whilst we can accept more risk given the time frame volatility should not be too high and we have used the Capital Preservation Portfolio that again provides the returns that we require. In the background the Capital Reserve is aimed at generating growth that will hopefully replace the capital spent in other segments as no income is required (it is of course there if needed).
If all goes to plan and in twenty years, the client achieves the target end value they would be in the same position as they were when they started; if returns are as expected based on historic performance then they will be better off. The Internal Rates of Return are fairly conservative and hopefully the client can see how their objectives may be met – it also gives us a chance to discuss if their objectives are actually achievable and it some circumstances has given potential client’s a bit of a reality check.
This approach is also helpful in the context of benchmarking returns; often a client portfolio will be compared to an arbitrary benchmark that can have little relevance to the individual’s circumstances. Introducing the concept of an Internal Rate of Return that is specific to individual objectives means that this becomes their own personal benchmark and they are “free” of the worry/ecstasy that following an index like the FTSE-100 can bring!
A lot of analysis, assessment and measurement of performance goes into selecting and the second table in image three provides a summary of three of the most used portfolio; their asset allocation and typical funds that they hold. As you can see in comparison to the Short Term Lifestyle Portfolio the Long Term Growth Portfolio is far more aggressive and focused on the provision on capital growth over a much longer time frame.
Short Term Lifestyle is heavily weighted to cash as we know some of that will be paid out for income in the first year or so and we are then looking to Fixed Interest to at least provide us with a reasonable return in the first few years. Taking Gilts as an example yes they probably are expensive in the longer term but short term there is value to be had in the income – particularly as our required rate of return is only 0.3%.
We were really able to take advantage of an opportunity in Long Dated Gilts in 2014 then again in 2015 when 30 Year Gilt Yields were almost at 3%; our thesis was that at some point these yields will become attractive to investors with low interest rates and low inflation – this proved to be the case as yields fell to below 1.25% in mid 2016 returning a capital gain of nearly 30%.
The Alternatives & Other is a little bit of a catch all segment and includes assets such as Absolute Return and what we view as Low Volatility Multi-Asset Funds; the Absolute Return sector has been successful provided some consistent returns but with large inflows to the sector over the last year or so we have been reducing exposure slightly. The Low Volatility Multi Asset Funds are what we consider excellent Investment Trusts that have consistently provided stable returns across numerous market cycles; these include Capital Gearing, Ruffer and RIT Capital Partners.
We have also been adding Hedge Funds into the Longer-Term Portfolio’s recently and really like Third Point Offshore Investors – after some stellar long-term performance 2016 was poor and we are now simply looking for a reversion to the what we hope is the normal in terms of performance. In the current difficult and rapidly changing market conditions the Multi-Asset and Hedge Fund flexibility we feel has a lot to offer for both shorter and longer-term portfolios.
If you ask a client the level of risk they would take with a portfolio that they need to provide income in the next five years it would be very different from the risk they would take with capital that they may not need to rely on for 10 or more years. Stretching out that investment time line means clients can take on a more appropriate level of risk (and without the need to meet a minimum level of yield); which opens the door to different asset classes and strategies rather than being stuck chasing income producing assets alone.
On this day
4th August 1914 – Britain Entered the First World War
