There are many issues raised by your supplementary question probably worthy of a thread on their own
Natural Yield vs Total return
Investment portfolios generally have two forms of return: a capital return that comes from growth of the assets over time and a natural yield which is received from those assets in the form of coupons, dividends and interest.
Natural yield investing, sometimes also referred to as income investing or an income-only approach, is a popular approach used by many retirees, trusts and charities that rely on investments to meet their cash flow needs. In this approach, a portfolio is constructed to target a specific yield and only the income physically produced by the portfolio is withdrawn on a regular basis.
The alternative to natural yield investing is usually referred to as total return investing. Here a broadly diversified portfolio is constructed to achieve the highest possible combination of both natural yield and capital growth. Where regular withdrawals are made, these consist of a combination of the income physically produced by the portfolio and some capital growth, realised through asset sales.
Building portfolios for natural yield doesn’t necessarily lead to a happy ending. The challenges of low current yields, income being unstable over the life of a portfolio and the risk introduced by chasing higher yielding assets are just too great for natural yield investing to give the best chance of achieving good outcomes for investors.
We therefore resist using a natural yield approach just because that’s what used to be prescribed by custom, or regulation/legislation that has been subsequently updated.
The "best" approach
The objectives at retirement can be boiled down to the following:
1. an overwhelming need for income and the sustainability of that income, and
2. a secondary (typically less important) need to leave assets for beneficiaries
The forces working against the achievement of these objectives can also be boiled down to the following:
1. financial market risk
a. this includes general market risk and sequencing risk
2. longevity risk
a. the time horizon in retirement is unknown
b. this speaks to the real risk of an investor outliving their capital base
We wanted to introduce real world constraints in a modelling framework to draw realistic conclusions and guidelines from our research. The largest differentiator of our research is that we used a simulation process to produce portfolios that take any number of different paths possible given the risk and return characteristics of the portfolio. As opposed to merely back testing a portfolio to what has happened in the past (effectively only one path of returns) we simulated thousands of different paths for each scenario. We feel that this is more robust because it is unlikely that the returns experienced over the last few decades will be repeated over the next few decades
Adaptive spending strategies – making sacrifices
What are the objectives in retirement? It really is quite simple and can be boiled down as follows:
The overwhelming requirement in retirement is that of a regular income to fund living expenses as well as unexpected or large adhoc expenses such as medical expenses, holidays, car replacements or house maintenance etc.
Going further than just establishing an income number can go a long way to managing our realistic expectations in retirement.
We believe that the most appropriate approach consists of dividing retirement spending into three discreet categories:
· Needs – basic non-discretionary expenditure to provide a baseline standard of living
· Wants – discretionary expenditure to maintain one’s desired lifestyle
· Wishes – luxuries that are not necessary to maintain one’s desired lifestyle
This approach immediately creates a more solid framework against which to plan for future expenditure.
Example
I might
want to go to the movies twice a week but I don’t
need to. I could equally borrow a book from the local public library for free or at the other extreme (
luxury) install a home cinema system.
Framing our income requirements in this way helps manage our retirement income journey and appreciate that from time to time, there may come a requirement to make some sacrifices.
A secondary yet important consideration for most of us is that of passing down a portion of our life savings to beneficiaries.
Spending assumptions throughout retirement
“Our findings suggest that typical consumption in retirement does not follow a U-shaped path – consumption does not dramatically rise at the start of retirement or pick up towards the end of life to meet long-term care related expenditures.”Dr Brancati, International Longevity Center
Consumption in retirement starts relatively high and ends low. This pattern is common to both high and low income groups, is robust to the inclusion of factors other than age and is not simply the result of the time period in which the data was collected.
Of course many people will need care in later life, but this is not typical. Consider the following
[1]:
• only 16% of people aged 85+ in the UK live in care homes
• the median period from admission to the care home to death is 462 days. (15 months)
• around 27% of people lived in care homes for more than three years, and
• people had a 55% chance of living for the first year after admission, which increased to nearly 70% for the second year before falling back over subsequent years
Marc Westlake CFP,TEP,APFS,EFP,QFA
Chartered Certified and European Financial Planner
www.globalwealth.ie
[1] Source Age UK (2016)