Putting Natural Yield Retirement Income to The Test
The global lockdown continues to throw up important lessons. In particular, it’s a useful time to test one’s thesis about investing and retirement planning. I’ve always thought that a good retirement strategy should hold up, not just in good times, but especially in bad times.
Every man and his dog can create a strategy that works well in a bull market when the value of investments are going up. The real test of an investment strategy is how it holds up at the worst of times.
The current market conditions reveal the fallacy of natural-yield-for-retirement-income right before our very eyes.
According to the UK Dividend Monitor from Link Group, within a few days from the middle of March, UK companies scrapped payouts to shareholders worth a staggering £25.4bn — around a third of the expected dividend for 2020 before Covid-19 hit. By April, nearly half of UK companies had already axed their pay outs (or are certain to do so)! In the worst-case scenario, dividends by UK Plc are expected to drop by a whopping 51% to £48bn a year.
Globally, the dividend story is only a little less painful. Global dividends are expected to decline by as much as $498 billion, a decline of some 35%, according to research by Janus Henderson. It estimates that more than a quarter of the 1,200 companies screened in its Global Dividend Index have cut or deferred at least one dividend payment this year.
Even Shell, the world’s biggest dividend payer for the best four years, cut its dividend by two-thirds. Shell is a top-10 holding in almost two-thirds of funds in the UK equity income sector, which has become increasingly concentrated on traditionally high-paying companies. More than two-thirds of projected dividends in the UK are paid out by just 10 companies. BP alone is expected to account for 10% of annual dividends, while HSBC which accounts for 6.3% of the UK’s dividends, has already cancelled its payout.
To be clear, the point here isn’t about dividend as a source of return for an equity investor. There’s never been any question about that. The problem is, relying entirely on dividend as an income source in a retirement portfolio isn’t a very good idea, as we’ve previously shown in this research note.
‘The illusion that relying on natural income mitigates sequence risk in a retirement portfolio is exactly that, an optical illusion. Once you take account of what really matters to a retiree (inflation-adjusted income), a natural yield retirement income strategy is grossly inefficient. Income varies on a monthly basis beyond what most retirees can tolerate. Retirees following this strategy must be willing to tolerate significant volatility in their income, including periods of prolonged reduction in real terms.’
In other words, a natural yield retirement income approach fails you at the exact point you need it to hold up — in severe market conditions. This is the exact opposite of what the Sustainable Withdrawal Rate (SWR) framework aims to do. It deliberately sets withdrawal at a level that would survive even the most severe market conditions within the last 100 years. The SWR is faring well so far in the current downturn.
Here’s the lesson, company boards don’t give a monkeys about your retirement income. Dividend is a capital allocation decision. It shouldn’t matter to an investor whether return on equity investments is via capital growth or dividends.
The Free Dividend Fallacy
There’s no logical reason to prefer dividend to capital growth i.e. £1 in dividend shouldn’t be considered more valuable than selling £1 of shares. But investors are hardly rational.
Why do people, particularly investment professionals, think of natural yield as a superior strategy for retirement income? This has been a puzzle for academic research for many years. In reality, dividend payment is merely a capital allocation decision made by companies.
In their paper, The Dividend Disconnect, Prof Samuel Hartzmark of the University of Chicago and his co-author David Solomon offer an explanation for why investors tend to prefer dividends. They document what they call the ‘free dividend fallacy,’ a behavioural error where individual and professional investors systematically treat dividend as free money that is disconnected from capital value or share price. Many investors view dividends as an independent source of income, like payment from a bond. The result is that, in a low interest rate environment, demand for dividend-paying stocks increases and that invariably reduces expected return. They concluded that:
‘Many individual investors, mutual funds and institutions trade as if dividends and capital gains are disconnected attributes, not fully appreciating that dividends result in price decreases. Behavioural trading patterns (e.g., the disposition effect) are driven by price changes instead of total returns. Investors rarely reinvest dividends, and trade as if they are a separate, stable income stream. Analysts fail to account for the effect of dividends on price, leading to optimistic price forecasts for dividend-paying stocks. Demand for dividends is systematically higher in periods of low interest rates and poor market performance, leading to lower returns for dividend-paying stocks.’
Nick Murray once observed
‘Equity investing solely for dividends risks cutting oneself off from the potentially significant growth of capital which has historically been generated by companies that do not pay a current cash dividend precisely because they are investing substantially all their earnings in their continued growth. Dividends—like share repurchases and reinvestment in future growth—represent a capital allocation decision on the part of a company’s management. That is, rational managers are constantly asking themselves what deployment of their earnings may, in their best judgment, produce the optimal return to their shareholders. Thus, as attractive and even comforting as a purely dividend-focused investment strategy may appear to the conservative equity investor, it isn’t one that I personally would ever follow, or recommend.’
There are other problems with natural yield investing. Some of world’s fastest growing companies don’t pay dividends, e.g., tech companies like Facebook, Amazon, Alphabet and Netflix. A natural yield portfolio that excludes these companies misses out on potential growth. Since dividend payment is a capital allocation decision, one reason these companies don’t pay dividends is that they can deploy capital better than hand it back to investors.
Excluding these companies from your portfolio increases portfolio concentration at the very least. At worst, it reduces potential return in the long term.
To conclude, the natural yield strategy is ill-suited for retirement income. The volatility of income makes budgeting incredibly challenging for retirees. This income volatility is exacerbated by the lack of flexibility that results from viewing capital as sacred. Furthermore, that’s no empirical evidence to support investor preference for dividend over capital growth.
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