Monday, November 19, 2012

Potential Dangers of Investing for Income

I've mentioned before that the American College is in the process of building a great resource of interviews about retirement income topics for its new Retirement Income Certified Professional (RICP) designation program, which it is slowly rolling out as a part of its he New York Life Center for Retirement Income. I'm very fortunate to have the opportunity to provide the world premiere for some of these videos. I could probably spend a year doing this daily, but I will try to be selective. 

Recently, I've seen a lot of references to people interested in using a strategy to invest for income and live off of their income in retirement.

Today's video is an interview with Colleen Jaconetti, a senior investment analyst at Vanguard, in which she describes some of the potential pitfalls of income investing. This is not to say that no one should try it, but just to make sure that you are clear about the risks you are taking. Anyone interested in investing for income should take the 20 minutes needed to watch this interview.

The issue is that your retirement income strategy can be based on a total returns perspective, or based on investing for income.

First of all, in some cases, these strategies can be the same. If your asset allocation is designed from a total returns perspective and you are able to live off the income provided by the portfolio and other income sources from outside the portfolio (Social Security, etc.), then everything is fine.

The problem is what to do in the case that the total returns portfolio does not provide as much income as you like. 

[The video shows a shocking graphic about how the income provided from a total returns portfolio has fallen so dramatically in recent years so that this may be a bigger problem now than it ever was before, see the analysis beginning at 2:20 in the interview] 

With the total returns perspective, what you do is maintain your strategic asset allocation but also consume some of your principal. 

With the income perspective the last thing you want to do is consume some of your principal, so you instead re-arrange your investments so that they provide enough income that you don't have sell any assets to meet spending needs. In other words, you chase for higher yields. Often this means either shifting to higher yielding dividend stocks, or shifting bond holdings in the direction of greater maturity or increased credit risk.

No one is saying that you should not do these things, but there are risks involved and you need to be aware of what you are doing, and whether you might ultimately be better off by using a total returns investing approach.

Risks for dividend stocks:

Makes portfolio less diversified relative to total stock market

Understand that dividend stocks are not bonds, the value of a portfolio is still highly correlated with the stock market and a stock downturn can still decimate the portfolio value

Dividend approaches tend to overweight value stocks relative to the broad market

Portfolio becomes more concentrated: the top 10 holdings in a dividend fund take up a much higher percentage of the total fund

Dividend stocks are currently priced rather high relative to future earnings and so have more potential to drop

There is a misconception that higher dividends means higher returns. The value of the portfolio drops by the amount of the dividend. Total wealth is not affected by a dividend payment. But the dividend may be taxed at a higher income tax rate rather than the capital gains rate. Higher yielding dividend stocks have historically provided about the same total return as low dividend stocks.   
  
Risks for higher yielding fixed income:

Switching to higher yielding longer-term bonds leaves investor more exposed to capital losses if interest rates increase. Long-term bonds are more volatile.

With current low yields, a small increase in interest rates will result in capital losses that cancel out the higher interest income. See the amazing chart at 13:45, which shows, for instance, that a 0.23% increase in long-term interest rates would wipe-out the benefit of holding them instead of holding Treasury bills. Note: this is a really scary aspect about holding a long-term bond mutual fund today. 

Switching to higher yielding corporate bonds leaves investors more exposed to default risk; if the stock market drops then corporate bonds also tend to drop as increased default risk works its way into interest rates     

More general risks

The income approach is less tax efficient, as where to take income with a total returns perspective is based more on tax considerations and allows for offsetting capital losses and capital gains

As she says: In essence, investors are trading higher current income for a higher risk to future income 



4 comments:

  1. There is a lot of good information in this video, but I think it has two shortcomings. The first is that it ignores a potent psychological issue. I suspect the original reason that clients (not planners) tend to want to use income-oriented strategies is that, for their whole lives, the clients have trained themselves not to dip into principal. They have the idea that reducing their principal is the first step towards real poverty and, of course, in some cases that could be true. Harvesting just the income and leaving the principal intact seems much safer. The clients presumably understand that stocks and bonds do gain and lose value, but that doesn’t look like a one-way trip in the same way that spending principal does. I think that it will often be necessary to overcome this belief in order to persuade many clients who currently spend only income to adopt a total return strategy; note, though, that RMD rules do force some liquidation of principal on tax-deferred accounts, so the issue is less of a problem there. Second, I was surprised that the possibility of annuitization was not even mentioned, even if just to point out that it was another possible strategy.

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  2. Very interesting and quite balanced treatment; although it is based on a US perspective, there are some general points that are more widely applicable.

    A couple of observations:
    - inflation is not really tackled: investmnt returns/yields need to be considered in the light of inflation at the time (the graph on historical returns was therefore possibly misleading?)
    - this was almost like being a patient and watching two doctors discussing your treatment: perhaps retired people with money to invest should be encourage to find out more themselves rather than rely on *advisers*, even if they are as objective as those in the interview
    - I can't see any reason why someone investing for income could still not use a total returns approach to taking money out from capital appreciation
    - the graph on total returns from the different quintiles of dividend stocks (indicating a pretty level 8% return, no matter whether there was a dividend or not) looks wrong: academic research has shown that usually those stocks from the second quintile of dividend payers do quite well.
    - focusing on income has another, perhaps more important psychological implication: you are more likely to look at your own expenditure - and reduce it!

    But still a lot of food for thought in the interview. A general rule of thumb is still: higher yield = higher risk

    http://www.the-diy-income-investor.com/

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    Replies

    1. Thanks for the good comments. In particular, it would be good to check further about that point about the total returns being the same regardless of the dividend yield, and your point about the psychology of controlling expenditures.

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  3. The problem with some many investors that are into investing in stocks that pay high dividends Is this. The yield of a stock will almost always follow the credit quality of the company paying the dividend. A company thats paying a dividend of 8 9 or even 10 percent will almost surly be in the non investment grade category or in the BBB category which is just one or two notches above non investment grade securities. Theirs a few exceptions like real estate investment trusts or some utility stocks a few of them could pay a dividend of 8% and still be in the investment grade category but its very rare to find a company with a A- or better credit rating on their debt thats going to have a dividend payout of 8% for example. Investors that invest in high yield dividend stocks should always keep in mind dividend yield = credit quality.

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