Designing better retirement portfolios with natural income

As UK investors increasingly face the challenge of generating sustainable income in retirement, advisers are tasked with crafting strategies that balance yield, capital preservation and growth potential. Paul Flood, Head of Multi-Asset and Charities, BNY Investments Newton, explores how natural income investing has emerged as a compelling approach within this landscape, offering a way to generate income directly from the underlying assets rather than relying solely on capital gains or frequent portfolio turnover.

Like any investment strategy, it comes with both benefits and potential drawbacks that advisers should carefully consider when constructing retirement income portfolios.

Natural income investing focuses on selecting assets that produce reliable and sustainable income streams, such as dividends from equities, interest from fixed-income securities, and distributions from ‘real assets’ such as infrastructure or property. The key distinction is that income is generated ‘naturally’ by the portfolio holdings themselves, rather than through selling assets or by employing complex derivative strategies.

A natural choice for retirement income?

There are several benefits of following a natural income approach for those needing a retirement income.

1. Aligning with client objectives

Where clients are seeking regular growing income, using a natural income approach may align more closely with the goal of regular, growing income compared to a total-return approach. Where the investment strategy is explicitly managed to support stable and growing income, it helps reduce the risk of a reduction in a client’s income.

2. Maintaining capital

Because taking a natural income does not involve selling investments, in theory, the client’s capital is maintained to support future income. However, the true picture depends on the assets held in the portfolio. Companies with a reputation for reliable and growing dividends make payments to shareholders after considering what portion of profits they should retain to maintain and grow their businesses over the long term. If a portfolio is constructed from a diversified mix of dividend-paying stocks and complementary assets, there is a stronger case for sustaining natural income distributions without significantly depleting the underlying capital base that drives future income.

3. Avoiding sequence of returns risk

Sequence of returns risk is where sharp asset-price falls combine with encashments to impair the sustainability of future income. This occurs because, if market prices are depressed, the client must sell more of their investments to generate their required income. Under a natural income approach, sales of securities should be unnecessary, so movements in the market price of assets have little influence on long-term income sustainability.

4. Managing inflation uncertainty

Recent years have reminded us that inflation can have a profound impact on a client’s income needs. One common response to this is to hold a greater proportion of clients’ assets in equities and real assets. However, under a total-return approach, increasing equities can lead to heightened volatility, therefore amplifying sequence of returns risk. When income is taken from the dividend yield on equities, it is not necessary to sell assets to meet income payments, and so are better able to withstand volatility. This can allow portfolios to hold a greater weight in equities and so provide greater inflation protection.

5. Staying fully invested

Under a total-return approach, advisers will often hold part of the portfolio in cash. Income can be drawn from this cash buffer in times of market stress to avoid the need to sell assets at depressed prices. While the cash allocation can be an effective way of managing downside risk to income, it can be a burden on overall portfolio performance and limit the client’s ability to generate the returns they need to achieve their objectives. While some level of cash buffer may be required when using the natural income approach, perhaps to provide for unexpected expenses, it is likely to be much smaller. This means more of the client’s assets can be invested to support income.

Potential risks of a natural income approach

Nevertheless, using natural income in retirement is not without its challenges.

While natural income can be more predictable than capital gains, it is not guaranteed. Firms can cut or even suspend dividends, as seen in 2020 when Covid hit. Interest rates can fluctuate, and real assets can be affected by economic cycles. Advisers must assess the quality and sustainability of income sources carefully.

Natural income streams, particularly fixed-income coupon payments, may not always keep pace with inflation. Without growth in income, retirees risk a decline in purchasing power over time.

In addition, focusing heavily on income can sometimes mean sacrificing capital growth opportunities. High-yielding assets may be more mature companies with slower growth prospects, potentially limiting portfolio appreciation.

Given these considerations, advisers have often combined natural income investing with other approaches, including systematic withdrawal plans, total-return investing, and the use of annuities and guaranteed products.

Natural income in practice

In our view, a carefully designed multi-asset approach can embody many of the principles of natural income investing while addressing some of its challenges. While many investment strategies focus on either maximising growth or maximising income, we believe that striking a balance between these two extremes can deliver an income that is reasonably stable and growing, while providing scope for capital appreciation over the medium to long term.

While this could, in theory, be achieved with a single asset class, the approach works best when delivered through an actively managed multi-asset portfolio. A broad investment universe can include income-generating assets such as UK and global equities, fixed-income securities, real assets, and alternative income sources. Different asset classes tend to have different income and growth characteristics. For example, we might expect fixed-income securities to offer a higher income yield than equities, while the latter are more likely to deliver capital growth over the medium to long term.

By actively managing asset allocation and security selection, a portfolio can seek to navigate the uncertain environment and inflationary pressures that many retirees face today. The flexibility to adjust exposure across asset classes provides the potential to capture income opportunities while mitigating downside risks.

Finally, income payments can be structured as 12 equal monthly payments, with a final balancing payment at the end of the year. This gives clients income in the form they are likely to have been used to while working – a regular salary with variable bonus. It also simplifies planning and administration as the level of regular income is known in advance.

For advisers, such an approach offers a ready-made solution that can form the core of a retirement income strategy, providing both natural income and the potential for capital growth. It also simplifies portfolio construction and ongoing management, freeing advisers to focus on client engagement and holistic financial planning.