How Australian equities can help meet retirement income needs

Michael Price explains why retirees should consider Australian equities for their income needs.

The prime reason we save and invest is so we will have enough money to meet our spending requirements during retirement. 

There are a number of aspects to retirement planning that are worth highlighting. The first is the need for income, rather than for assets. Essentially when we retire we are trying to replace our income with investments.

Secondly, we need our income to pay for goods and services. As the price of goods and services changes with inflation, our need for income increases with inflation over time.

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Finally, the need for income to spend will continue as long as we are still alive. We desire an investment strategy that ensures we do not outlive our savings.

The possibility of out-living our ability to generate income, due to increasing life expectancy, is a longevity problem that is gaining increasing awareness within the community.

The simple solution

There is a very simple strategy that will ensure you do not outlive your capital. That is, to simply live off your income and not drawdown on your capital at all. If you don’t touch your capital, it will never run out!

However, in practice you may want or need to spend some of your capital to meet minimum living requirements. 

What sort of income?

The next step is to calculate the minimum income stream that is sustainable for life, and identify the appropriate type of income stream.

One traditional option would be to invest in longer-term fixed income assets that will provide a steady income over time.

In the past, this option could have provided a reasonable level of income. In recent times however, the yield on long-term government bonds are not just below average, but at record lows.

During the course of June and July this year, Australian 10-year yields hit an all-time low, falling below 3 per cent.

Overseas it is just as bad – US treasuries also reached all-time lows, while Dutch bonds recorded their lowest yield in nearly 500 years of record keeping! No wonder investors are starting to look elsewhere for their income needs.

But there is also another big problem with government bonds. The income returns are nominal, not real. The income you receive won’t grow over time, but instead will be reduced by the impact of inflation.

When your need is for a growing income stream that will rise over time, nominal assets don’t meet that basic need as they do not provide protection against inflation. 

The importance of growing income

How important is growing income?

Consider the case of Telstra compared with BHP; if you were to invest $10,000 in Telstra at the start of 2000, it would have paid you a little over $6,000 in gross dividends over the period and $483 over the past 12 months.

On the other hand a similar investment in BHP would have paid you just under $12,000 over the period and $1672 over the last 12 months.

BHP would have paid almost twice as much over the period, and three times as much in the past year.

While Telstra is known as an income stock, the growth of capital in BHP has increased the capital from which the dividends are derived.

Who said BHP wasn’t an income stock?

Looking at similar figures from an index point of view, if you had invested $100,000 in the S&P/ASX200 30 years ago, you would have earned approximately $31,000 in dividends over the past year (and your investment would now be worth more than $670,000).

Conversely, a bank deposit of the same amount at the time of investment would have paid just under $5,000 last year, and its original value is worth 70 per cent less in real terms today. 

The capital growth component equities have proven to offer over the longer term is key to increasing the dividend base over time. 

Note: 30-year Investment from 1 January, 1982 to 1 January, 2012, using All Ordinaries index until 1992. Source Bloomberg, RBA. 

Australian equity yields compared with term deposit rates

Having established the long-term desirability of Australian dividend income, the next question is just how much income do we need to give up in the short-term in order to get the benefits of the growing income stream?

Right now, the answer is none whatsoever. In fact we get paid up-front for choosing a growing income stream, rather than one that is steadily declining from the impact of inflation.

Graph 1 compares the grossed up yield including franking credits of the S&P/ASX200 index, with the average one-year term deposit rate of the major banks.

We can see that for most of the period you do have to give up some short-term income to reap the benefit of a growing income stream.

But right now the situation is reversed. Global interest rates are so low that dividend yields are higher than the rates being paid by the banks.

At the moment you don’t have to give up any income even in the short term to access the growing income stream.

Income certainty versus capital certainty

Unfortunately, in financial markets there is no such thing as a free lunch. You do have to give up something if you move from bank deposits to equity investments.

The main benefit that you give up is the certainty that you will get a full return of your invested capital.

However, there are two aspects of this that are not very well appreciated.

Firstly, although banks provide capital certainty, there are no long-term guarantees as to the rate of income that they will provide. 

Remember the point of the exercise is to provide income for life.

For a couple aged 60 visiting a financial planner there is a greater than 50 per cent chance that at least one of them will live past the age of 90. That is a 30-year investment horizon.

But who has any idea what bank term deposit rates will be even in 10 years’ time?

Currently cash rates are less than 1 per cent in the US, Japan, the UK and some nations in the European Union. It is possible that Australia could experience such low rates at some point over the next 30 years.

Graph 2 plots the frequency distribution of official Australian cash rates, US cash rates and Australian dividend yields, taking one sample point for each of the past 50 years.

It can be seen that dividends are far more tightly clustered – more certain – than cash rates. 

Based on this, you can have a higher degree of confidence that dividend yields will remain in the range of 2.5 per cent to 6.5 per cent over the next 30 years. But you certainly can’t say the same about cash or term deposit rates.

The second issue is to consider just how important capital volatility is? Equity markets are well known to fluctuate through investment cycles and differing economic environments.

However, if you’re not touching your invested capital and are living off your income, capital volatility is only an issue for your children and not for you at all.

Of course in practice it is still a consideration, but it might be far less important than you think.

And if the alternative is a bank deposit yielding less than 1 per cent, then capital volatility might be the price you have to pay.

The rise of Australian equity income funds

Australian equities can play an important part of the asset mix to meet the longer-term needs of retirees.

Their characteristics of capital growth and steady income provide protection against inflation that nominal assets cannot. Australian equities also provide more income certainty than bank deposit rates can. 

Managed Australian equity income funds are one such investment instrument that aims for capital growth above inflation while increasing the portfolio mix to income-oriented shares. 

The key is to find a fund that is designed to achieve the right mix of income and growth, and where the investment manager is able to change the mix while still generating alpha and not giving up too much in total return.

As a portfolio manager, I can tell you it is a challenge to do both.

Michael Price is a senior portfolio manager at AMP Capital.