Should you switch from accumulation to income funds when decumulating?

Pat38493

A recent post made me realise that I need to educate myself a bit more on potential drawdown strategies with respect to investment yield.

If I understood the post correctly, the idea was that you should be taking the yield (which I understand to be the dividend income or coupons?) to keep your cash float topped up, even when markets are significantly down.

However if that's a good idea, does that mean that you have to switch at least some of your portfolio to income funds, or could you effectively achieve the same thing by selling the value equivalent of the 12 month yeild each year (even if the price is down)?  If I followed it, the theory is that you are not crystallising losses if you are only taking out the income that was made, and not selling the capital value?

The other question I have is - does this also imply that once in decumulation, it's a good idea to  have some funds that are specifically designed to generate income i.e. a bigger portion of the returns is yield?

This is a part I had not really investigated much before as i kind of assumed that it would all come out in the wash, so I would just use accumulation fund for everything.

JohnWinder

Spending from a cash account, or from dividends or from capital sales, remember money is fungible. Considering the 'dividend fallacy' might further shed some light.

LHW99

The problem in relying on yield alone, is that unless you go for high yield (5%+), many people would not get a sufficient income, and high yield shares / funds tend not to increase in value, so you can have problems keeping up with inflation.

The problem with relying on selling down from capital (only) is that when the market enters a prolonged downturn, you are having to sell more shares / units to maintain the income.

If your DC portfolio can generate sufficient ~3% income for your needs (perhaps you have a DB pension, or some annuity income as well) hen you can probably use annual yield. This may do away with a need for a large cash buffer, because equity yield rarely drops to quite the same extent as capital values. You won't be selling units, so the capital value will come back up in due course, while the yield keeps on coming in. I have seen that with a small portfolio during the financial crash.

If you use the total return / sell capital shares, you probably need a larger buffer to avoid having to liquidate too much of your holding when shares drop (growth shares often provide a low <2% yield).

My understanding is that the "dividend fallacy" is used to talk down the use of equity dividends for income, because companies can either pay out from earnings, or re-invest it, so growth or dividends are equivalent. However, IMO there are nuances, partly as described above, but also because for the average investor, wotking out whether those companies that retain the earnings (rather than pay it out) actually invest it to sensibly grow the company, or whether too much goes into eg bonuses or is wasted by inappropriate purchases is very difficult to judge.

Diversification in investment type (income / growth) as well as geography etc is ideal if you can manage it - so a growth "pot" to top up the "income pot" from time to time when things are going well, plus a cash "pot" for when they're not.

Linton

In my case income funds fill the gap between guaranteed income such as State Pension and what is needed for day to day expenditure.  Achieving that requires a very different portfolio rather than just switching your existing general funds from Acc to Inc as it requires funds that can produce something like 6% income.  These could include corporate bond funds, certain specialist equity funds and other funds like REITs and infrastructure funds which would be unlikely to form a signirficant part of a general or growth portfolio.

Just as with an equity portfolio It is important in an income portfolio to ensure high diversification which should include a range of asset types, geographies, industry sectors etc.

Having a set of high dividend funds gives room for much of the rest of your retirement pot to be held in 100% equity growth funds, without any need for padding from gilts or similar.  Their purpose is to provide long term inflation matching and as there is no ongoing drawdown from the growth funds equity crashes can be pretty much ignored.

Properly constructed income funds can deal with crashes and also can provide fairly stable on-going income.  What's not to like?

JohnWinder

'and what is needed for day to day expenditure.  Achieving that requires a very different portfolio rather than just switching your existing general funds from Acc to Inc as it requires funds that can produce something like 6% income'

A couple of points before anyone is tempted to try this at home.

Maybe something like 3%/year income would do if you put twice as much into this segment of a portfolio! I don't see that it stands or falls over it being 6%. 

Secondly, is the 6%/year before or after inflation? If it's before inflation, then it becomes 4.9% after 5 years of 4%/year inflation; is it then time to top it up by 20%? If it's 6% after inflation, then it might be wishful thinking, as global stocks have returned about 4.9%/year real over the last 30 years.

Thirdly, it sounds so easy and assured; but it is simply equivalent to a multi-asset fund that contains stocks, bonds, and REITS in its composition, about which people agonise endlessly as they try to grapple with SOR risk. As I'm sure we've seen many times before in discussions here, any particular drawdown strategy will be the best or far from the best depending on the financial environment we retire into.

Pat38493

JohnWinder said:

'and what is needed for day to day expenditure.  Achieving that requires a very different portfolio rather than just switching your existing general funds from Acc to Inc as it requires funds that can produce something like 6% income'

A couple of points before anyone is tempted to try this at home.

Maybe something like 3%/year income would do if you put twice as much into this segment of a portfolio! I don't see that it stands or falls over it being 6%. 

Secondly, is the 6%/year before or after inflation? If it's before inflation, then it becomes 4.9% after 5 years of 4%/year inflation; is it then time to top it up by 20%? If it's 6% after inflation, then it might be wishful thinking, as global stocks have returned about 4.9%/year real over the last 30 years.

Thirdly, it sounds so easy and assured; but it is simply equivalent to a multi-asset fund that contains stocks, bonds, and REITS in its composition, about which people agonise endlessly as they try to grapple with SOR risk. As I'm sure we've seen many times before in discussions here, any particular drawdown strategy will be the best or far from the best depending on the financial environment we retire into.

Yes this is all understood.  I think the main question for me was, (to use extreme numbers) if there is a 40% market crash and the value of my xyz fund dropped by 40%, but a year later, the value is still way down, but the 12 month yield says for example 3%.  If I then take out 3% of the value (now or at the date 12 months ago???) does this mean that I am actually not crystallizing any losses because I didn't sell any capital theoretically, or am I talking nonsense there?

Linton

JohnWinder said:

'and what is needed for day to day expenditure.  Achieving that requires a very different portfolio rather than just switching your existing general funds from Acc to Inc as it requires funds that can produce something like 6% income'

A couple of points before anyone is tempted to try this at home.

1) Maybe something like 3%/year income would do if you put twice as much into this segment of a portfolio! I don't see that it stands or falls over it being 6%. 

2) Secondly, is the 6%/year before or after inflation? If it's before inflation, then it becomes 4.9% after 5 years of 4%/year inflation; is it then time to top it up by 20%? If it's 6% after inflation, then it might be wishful thinking, as global stocks have returned about 4.9%/year real over the last 30 years.

3) Thirdly, it sounds so easy and assured; but it is simply equivalent to a multi-asset fund that contains stocks, bonds, and REITS in its composition, about which people agonise endlessly as they try to grapple with SOR risk. As I'm sure we've seen many times before in discussions here, any particular drawdown strategy will be the best or far from the best depending on the financial environment we retire into.

1) 6% yield is about as high as you can reasonably get from a widely diversified set of funds.  For example you wont get much more than that from dividends in normal times. It also leaves enough money for a viable  100% equity growth portfolio that over the long term produces sufficient return to grow the income portfolio to at least match inflation.

2) 6% is the initial yield from the income portfolio when it is set up. If this income becomes inadequate, perhaps from inflation or some other requiement for more ongoing expenditure or failure of individual funds,  the income portfolio can be occasionally topped up from the growth portfolio.  

3) The strategy is not equivalent to a single multi-asset fund since it is in much less danger from SOR.  This is achieved by never taking expenditure directly from the growth portfolio, but rather from the income portfolio returns which are far more stable in an economic downturn than equity value.

Once you have understood this basic strategy then the next step is to  pay all income including SP, DB pensions, annuities plus the returns from the income portfolio into a buffer from which all expenditure is taken.  If you have planned prudently the buffer will increase over time and so provide for one-off expenditure and further cover for economic events without selling growth funds.

My experience is that this can be created from a 60% equity, 40% others overall asset allocation.

Notepad_Phil

Pat38493 said:

JohnWinder said:

'and what is needed for day to day expenditure.  Achieving that requires a very different portfolio rather than just switching your existing general funds from Acc to Inc as it requires funds that can produce something like 6% income'

A couple of points before anyone is tempted to try this at home.

Maybe something like 3%/year income would do if you put twice as much into this segment of a portfolio! I don't see that it stands or falls over it being 6%. 

Secondly, is the 6%/year before or after inflation? If it's before inflation, then it becomes 4.9% after 5 years of 4%/year inflation; is it then time to top it up by 20%? If it's 6% after inflation, then it might be wishful thinking, as global stocks have returned about 4.9%/year real over the last 30 years.

Thirdly, it sounds so easy and assured; but it is simply equivalent to a multi-asset fund that contains stocks, bonds, and REITS in its composition, about which people agonise endlessly as they try to grapple with SOR risk. As I'm sure we've seen many times before in discussions here, any particular drawdown strategy will be the best or far from the best depending on the financial environment we retire into.

Yes this is all understood.  I think the main question for me was, (to use extreme numbers) if there is a 40% market crash and the value of my xyz fund dropped by 40%, but a year later, the value is still way down, but the 12 month yield says for example 3%.  If I then take out 3% of the value (now or at the date 12 months ago???) does this mean that I am actually not crystallizing any losses because I didn't sell any capital theoretically, or am I talking nonsense there?

if you could rely on the fund price remaining static over the year and continue right up until the sale instruction is executed, then yes I think theoretically you could do that based on the current dividend yield, but the problem is that prices aren't going to remain static, so it would be much easier if you had Inc type units.

JohnWinder

'Yes this is all understood.  I think the main question for me was, (to use extreme numbers) if there is a 40% market crash and the value of my xyz fund dropped by 40%, but a year later, the value is still way down, but the 12 month yield says for example 3%.  If I then take out 3% of the value (now or at the date 12 months ago???) does this mean that I am actually not crystallizing any losses because I didn't sell any capital theoretically, or am I talking nonsense there?'

Here goes, but your question isn't clear: 'says' I don't get; now or 12 months ago, which is it?

In you scenario, you could choose to only take dividends (let's say it's 3% of the value of the assets which are coming as dividends). No selling, no crystallising lost capital value, all hunky-dory. Alternatively, in your scenario, you could simply sell 3% of your assets when the price is down, crystallising lost capital value, and reinvest the dividends which were to the same value as the assets you sold, thus buying back (or using accumulation units) more of the assets. There seems to me no difference with respect to the well-being of your investments; one might be more tax efficient, or it might incur more transaction costs, or it might result in more paperwork etc, but neither protects your investments better than the other. Am I missing anything?

JohnWinder

'It also leaves enough money for a viable  100% equity growth portfolio that over the long term produces sufficient return to grow the income portfolio to at least match inflation.'

Here is why I say don't try this at home. Not everyone has so much wealth that after sequestering enough to provide the necessary income at 6% there is enough left for the growth portfolio. The approach you describe, lovely for the right people, lacks universality.

'3) The strategy is not equivalent to a single multi-asset fund since it is in much less danger from SOR.  This is achieved by never taking expenditure directly from the growth portfolio, but rather from the income portfolio returns which are far more stable in an economic downturn than equity value.'

'Much less danger..;' I don't know how we measure such danger or can test this, but I'm skeptical.

By the by, crystallising losses is not the bete noire it can be made out to be. An all equity portfolio suffering a 50% crash will suffer no SOR damage if you sell the same percentage of assets as you would without the crash. If you normally sell 5% of your funds in the good times, then selling 5% of them in the bad times will have no SOR risk other than give you less income to spend. Simply, if your retirement portfolio isn't big enough to allow a small enough withdrawal rate so you can sail through the bad times without risking you dying broke, then you have to be flexible in your drawdown however that's achieved.

'3) The strategy is not equivalent to a single multi-asset fund since it is in much less danger from SOR.  This is achieved by never taking expenditure directly from the growth portfolio, but rather from the income portfolio returns which are far more stable in an economic downturn than equity value.'

As an equity-only collapse is occurring a multi-asset fund which rebalances is progressively buying cheaper and cheaper equities which will show more growth than the existing equities when recovery times arrive. The approach you describe misses out on that benefit. Indeed your approach could still require selling reduced price growth assets if the 6%/year dividend segment is not providing enough. Again, one either has enough that there's nothing to worry about, or you have to be flexible.

Pat38493

JohnWinder said:

'It also leaves enough money for a viable  100% equity growth portfolio that over the long term produces sufficient return to grow the income portfolio to at least match inflation.'

Here is why I say don't try this at home. Not everyone has so much wealth that after sequestering enough to provide the necessary income at 6% there is enough left for the growth portfolio. The approach you describe, lovely for the right people, lacks universality.

'3) The strategy is not equivalent to a single multi-asset fund since it is in much less danger from SOR.  This is achieved by never taking expenditure directly from the growth portfolio, but rather from the income portfolio returns which are far more stable in an economic downturn than equity value.'

'Much less danger..;' I don't know how we measure such danger or can test this, but I'm skeptical.

By the by, crystallising losses is not the bete noire it can be made out to be. An all equity portfolio suffering a 50% crash will suffer no SOR damage if you sell the same percentage of assets as you would without the crash. If you normally sell 5% of your funds in the good times, then selling 5% of them in the bad times will have no SOR risk other than give you less income to spend. Simply, if your retirement portfolio isn't big enough to allow a small enough withdrawal rate so you can sail through the bad times without risking you dying broke, then you have to be flexible in your drawdown however that's achieved.

'3) The strategy is not equivalent to a single multi-asset fund since it is in much less danger from SOR.  This is achieved by never taking expenditure directly from the growth portfolio, but rather from the income portfolio returns which are far more stable in an economic downturn than equity value.'

As an equity-only collapse is occurring a multi-asset fund which rebalances is progressively buying cheaper and cheaper equities which will show more growth than the existing equities when recovery times arrive. The approach you describe misses out on that benefit. Indeed your approach could still require selling reduced price growth assets if the 6%/year dividend segment is not providing enough. Again, one either has enough that there's nothing to worry about, or you have to be flexible.

In other words there is no free lunch?  To follow Liniton's approach in the end you need a bigger starting fund as a fund that yields 6% year on year is unlikely to grow much in capital terms and might actually shrink.

Further, I have not researched this much, but I doubt that the fund would continue to deliver 6% income in a massive economic depression - even the best companies might be forced to cut dividends.

What's also not helpful is that there doesn't seem to be a lot of historic data around about how much income these type of funds yielded annually during all parts of the economic cycle.