Should I choose income or growth?

orangello

IFAs often talk about structuring a portfolio towards ‘income’ rather than ‘growth’ at retirement. What does this mean in practice? Is this moving to funds that generate dividend yield and corporate bond funds and can you give an example of what would an ‘income’ portfolio may look like?

If investments are diversified in UK and global equities and bonds and averaging 6-7% growth p.a. why not keep it as it is and take out about 4% each year and leave any surplus in good years to compound growth and offset the effect of inflation?

If markets fell and the portfolio falls 20% in value one year, then 4% income would still be 20% less income whether it came from 4% the total fund value or a 4% dividend yield on the fund value. So why not stay focussed on growth rather than switch to income and have a portfolio which has little surplus left over to reinvest and is more at risk of falling behind over time?

dunstonh

What does this mean in practice?

it is a change of focus on the fund to include greater income producing assets IF the that is the chosen investment strategy for post retirement (there are multiple suitable strategies)

If investments are diversified in UK and global equities and bonds and averaging 6-7% growth p.a. why not keep it as it is and take out about 4% each year and leave any surplus in good years to compound growth and offset the effect of inflation?

That is another strategy although you need to be careful with volatility and typically need to segment your portfolio. Although using a mixture of income assets and growth assets may suffice

If markets fell and the portfolio falls 20% in value one year, then 4% income would still be 20% less income whether it came from 4% the total fund value or a 4% dividend yield on the fund value. So why not stay focussed on growth rather than switch to income and have a portfolio which has little surplus left over to reinvest and is more at risk of falling behind over time?

The problem there is that people rarely take 4% of their current value. They will set a monetary figure and if the portfolio falls 20%, they will continue to take that monetary figure making it difficult for the portfolio to recover.

Your_Hero

The main reason is because growth portfolio's have greater volatility. There's a risk with the sequence of returns, i.e. if you are drawing income by encashment of units, and the portfolio had dropped in value then the total loss to your portfolio is even greater.

Your average 6-7% return could look like this:
Year 1: -18%
Year 2: +18%
Year 3: +18%

Or:
Year 1: +18%
Year 2: +18%
Year 3: -18%

The "average" return on both is 6%, but there is a very big difference to the overall value of portfolio when you are drawing income, with the first example leading to a much lower pot overall and will take years to recover. By using an income portfolio, you could reduce this risk at the expense of future (greater) growth.

orangello

dunstonh wrote: »

it is a change of focus on the fund to include greater income producing assets IF the that is the chosen investment strategy for post retirement (there are multiple suitable strategies)



That is another strategy although you need to be careful with volatility and typically need to segment your portfolio. Although using a mixture of income assets and growth assets may suffice



The problem there is that people rarely take 4% of their current value. They will set a monetary figure and if the portfolio falls 20%, they will continue to take that monetary figure making it difficult for the portfolio to recover.

So you may be OK having a growth portfolio if you are controlled in always taking the target % and not a target £?

Question: how is this different with an income portfolio - if markets fell dramatically wouldn't the beneficiary also get less than their target £ - if the portfolio is structured to yield x% of the total investments and the total investments fall then that x% is going to be worth less? Income or growth, surely you can only withdraw a target % every year or you risk depleting the funds?

orangello

Your_Hero wrote: »

The main reason is because growth portfolio's have greater volatility. There's a risk with the sequence of returns, i.e. if you are drawing income by encashment of units, and the portfolio had dropped in value then the total loss to your portfolio is even greater.

Your average 6-7% return could look like this:
Year 1: -18%
Year 2: +18%
Year 3: +18%

Or:
Year 1: +18%
Year 2: +18%
Year 3: -18%

The "average" return on both is 6%, but there is a very big difference to the overall value of portfolio when you are drawing income, with the first example leading to a much lower pot overall and will take years to recover. By using an income portfolio, you could reduce this risk at the expense of future (greater) growth.

I'm sure you are right, but how does the first example lead to a lower pot? I tried these sequences on excel and they both end up with the same size pot:

£100,000
£82,000
£96,760
£114,177

£100,000
£118,000
£139,240
£114,177

Your_Hero

orangello wrote: »

I'm sure you are right, but how does the first example lead to a lower pot? I tried these sequences on excel and they both end up with the same size pot:

£100,000
£82,000
£96,760
£114,177

£100,000
£118,000
£139,240
£114,177

You haven't included the income withdrawal from year 1.


Edit: Here's a link with an example, I've seen better ones but this is the only one I can find at present (page 10 onwards for the meaty stuff) http://www.peterwilmot.metlife.com/files/41120/RETINCWPCLIENTM~001.pdf

Your_Hero

orangello wrote: »

So you may be OK having a growth portfolio if you are controlled in always taking the target % and not a target £?

Question: how is this different with an income portfolio - if markets fell dramatically wouldn't the beneficiary also get less than their target £ - if the portfolio is structured to yield x% of the total investments and the total investments fall then that x% is going to be worth less? Income or growth, surely you can only withdraw a target % every year or you risk depleting the funds?

Just saw this post.

It's possible to use a growth portfolio to produce income on a % withdrawal basis. Has its pros and cons. The main drawback being volatility so your 5% one year would be different in monetary amounts to the next.

Whereas using an income portfolio, there would be less fluctuations and would focus more on natural income/dividends whilst hopefully maintain a stable capital base. The obvious downside is much lower potential for growth, and little prospect for rising income.

All depends on objectives, risk profile and capacity for loss.

orangello

Interesting link Your Hero, thanks.

FatherAbraham

orangello wrote: »

If investments are diversified in UK and global equities and bonds and averaging 6-7% growth p.a. why not keep it as it is and take out about 4% each year and leave any surplus in good years to compound growth and offset the effect of inflation?

Because 4% is way too high for a drawdown rate.

Warmest regards,
FA

orangello

FatherAbraham wrote: »

Because 4% is way too high for a drawdown rate.

Warmest regards,
FA

If average growth is 6-7% and 4% is withdrawn that leaves 2-3% rolled over to increase the fund size. At the current rate of inflation, that should keep the total fund size maintained relative to inflation? What would you suggest is a reasonable rate to withdraw and why?

FatherAbraham

orangello wrote: »

If average growth is 6-7% and 4% is withdrawn that leaves 2-3% rolled over to increase the fund size. At the current rate of inflation, that should keep the total fund size maintained relative to inflation? What would you suggest is a reasonable rate to withdraw and why?

Because of Wade Pfau's work: http://theretirementcafe.blogspot.co.uk/2014/07/half-right.html?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed:+TheRetirementCafe+(The+Retirement+Cafe)

4% was already too high when markets were returning good results. In the present investment era, it's suicide.

Warmest regards,
FA