Many investors have a longstanding obsession with generating portfolio income, and their bias is exacerbated in a low interest rate environment. It is often income from an investment, in the form of interest or dividends that is viewed as the primary consideration. A new retiree’s focus shifts from building wealth to managing and preserving it. One major challenge is to make the investment portfolio supply cash flow for the duration of life of the investor – and through different economic and market conditions.
Meeting a specific cashflow need is an important element of portfolio management. The expected return and volatility of a portfolio must be factored into consideration when determining sustainable income drawdown rates. Income should not be the primary concern. In many cases, taxable investors with a need for cashflow are better off minimising portfolio income.
Investors drawing on their portfolio need cashflow, but this can comprise two components: income, and cash from the sale of stocks and shares. Investors often gravitate toward the income element of the portfolio without properly considering all of the relevant issues, leading to a less efficient investment solution. The following discussion touches on important aspects of the income versus cash flow distinction.
The Promise of Income
So many active fund managers promote their products via the promise of income. The problem with these active funds includes high turnover, large trading costs and the concentration of risk. So why the scarcity of passive funds specifically designed for the income investor?
Most index funds are based on an aggregated market capitalisation of an index. A process which selects holding in individual companies yielding the largest dividends would change the nature of the risk in the portfolio and result in more concentrated risk.
The focus on income may generate a significantly higher tax liability and restricts the choice of available investments which effectively increases overall portfolio risk. Sacrificing or reducing high growth opportunities in favour of getting ‘more income’ is likely to result in a portfolio full of pharmaceutical companies, banks and distressed debt.
Do Dividends Matter?
The emphasis on dividends stems from the notion that a high dividend yielding stock constitutes a less risky investment because of the regular payments. Conventional wisdom tends to be that the regular payments protect you on the downside, since if the stock declines in value, you at least get your dividend. This perceived logic is empirically flawed. Dividends payments are not created out of thin air; they come from the company’s earnings or assets. When dividends are paid, the distributions reduce the value of the company stock by the amount of the dividend.
Part of the conventional wisdom is that a high dividend yield may help you avoid encroaching on capital in order to generate a cashflow. However, a dividend distribution encroaches on your capital and the company does this for you! The economic impact is essentially the same as if you had sold the stock.
Risk and Return
Dividends are often erroneously considered to be synonymous with profits. This misconception leads to the view that high dividend yielding companies are more profitable and less risky, when in fact dividends are often not related to profits.
Dividends are cash distributions. Very profitable firms may not pay dividends. Conversely, some companies (or ‘income trusts’) have paid distributions in excess of their profits. The latter is not sustainable, and dividends must ultimately reflect a return of investor’s capital or some of a firm’s earnings to shareholders.
Many investors seek companies with a high dividend yield because they want income from their portfolio, on the premise that these companies are less risky. What these investors actually need is cashflow. In this instance, their pursuit of income biases their asset allocation towards stocks of riskier companies.
The alternative to meeting a cashflow through dividend payments is to create ‘synthetic’ dividends by selling securities in the portfolio. This approach is often deemed undesirable because selling is considered an encroachment on capital that may result in ‘locking-in’ a loss if the stock price has dropped. This view is not empirically sound as discussed earlier, since dividends do not necessarily change the underlying value of the portfolio.
Synthetic dividends are more tax efficient than ordinary dividends because generating cashflow from the sales of stocks and shares produces capital gains (or losses) which are taxed at lower rates. Furthermore, this lower rate of tax is only applied to the portion of the cashflow which represents a capital gain, whereas the tax rate for a dividend is applied to the full amount. A non-reclaimable 10% tax credit is also withheld from dividends. This tax credit is still non-reclaimable if generated within an ISA or pension wrapper.
A final consideration for the income versus cash flow decision is the implication for rebalancing. Generating cashflow from sales not only results in more efficient tax management, but also provides an opportunity to rebalance by selling assets that are overweight relative to the recommended asset allocation of the portfolio. Conversely, dividends only allow for rebalancing when the amount of the dividend payment in excess of the cash flow need is reinvested into assets that are underweight.
An investor’s approach to generating cash flow does affect total wealth, net of taxes:
This example assumes an investor’s highest rate of income tax is 40% and the tax on the dividend includes the 10% non-reclaimable tax credit.
After tax, an investor is clearly better off through the synthetic dividend route with careful use of the Capital Gains Tax allowance.
Bonds – Another take on Income versus Cashflow
Investors generally hold bonds for two reasons: (1) to reduce overall portfolio volatility; or (2) generate a reliable income stream. Investors using the first approach want to hold fixed income securities that are lower risk to temper portfolio volatility. The second purpose is particularly relevant to income-oriented investors such as retirees, who may not worry as much about short-term volatility; they design a portfolio around bonds and accept more volatility in hope of earning higher yields, which they pursue by holding bonds with longer maturities and/or lower credit quality.
Market equilibrium suggests that higher yielding bonds have lower prices for a reason. A ‘high-yield’ bond is a bond which is rated below investment grade. These bonds have a higher risk of default or other adverse credit events, but typically pay higher yields than better quality bonds in order to attract investors. Let’s examine Greek Debt for instance; 10 year Greek Government Bonds currently yield 22.86% (Source: European Central Bank, as at March 2012). An examination of Greek default throughout history shows that the combined years throughout which Greece was in default between 1826 and the present day is a total of 90 years. This is approximately 50% of the total period that the country has been independent.
There is nothing inherently wrong with taking more risk in your bond portfolio, provided it is well diversified, low cost, tax sensitive, and prudently managed. However, risk decisions should consider the total portfolio and an investor’s overall risk preference, rather than being driven purely by a desire for income.
A behavioural bias known as mental accounting may prompt investors to overemphasis investment income in their portfolios. An example of mental accounting based on the intended use of funds is putting money for a child’s education in a low interest earning savings account while carrying a balance on a high interest bearing credit card. In this instance, the importance of the intended use of the money (i.e., education) means it is not used to pay off expensive debt, even when doing so results in a net economic benefit.
Labelling effects influence mental accounting, and this offers one explanation of why firms even pay dividends. If a company wants to distribute earnings to shareholders, it can choose to pay a dividend or it can repurchase shares. These two alternatives have the same economic impact before taxes, but if dividend tax rates are higher than capital gains tax rates, taxable investors would prefer share repurchases over dividends. In this scenario, firms should never pay dividends.
The bottom line is: When you move money from your left pocket to your right pocket, you are no better off; and in some cases, a few coins can slip between your fingers for the taxman to collect.
Biasing a portfolio toward companies with higher dividend yields or bonds with an increased yield to maturity is putting the cart before the horse, unless the decision reflects a risk preference rather than an income preference! Once the overall allocation decision has been made on the basis of total portfolio risk and return, the income produced becomes a by-product.
The solution is an evidence-based approach to achieving total returns. By using an evidence-based approach, a client can adapt the withdrawal rate to suit their needs, taking into account factors such as appetite for risk, which might change over time, change in circumstances, and the returns actually achieved. Income should be extracted through the most tax efficient vehicle first.
Our role is to ensure that the overall drawdown rate is sustainable, ensuring that portfolio has been considered, then taking responsibility for meeting the cash flow need in the most tax-efficient manner.
Portfolios should be designed to reflect risk tolerances while considering the impact of expected returns and volatility on sustainable drawdown rates and vice versa. Portfolio management then shifts to implementing the desired asset mix while reducing income for taxable investors.
Here is a summary of the main reasons why:
- Investors have cash flow needs, not income needs.
- Cash flow can come from income and/or security sales.
- High dividend yielding stocks may be more risky.
- Dividends do not protect you on the downside.
- Dividends do not prevent you from encroaching on your capital.
Important Disclaimer Notice
- All statements concerning the tax treatment of products and their benefits are based on our understanding of tax law and Inland Revenue practice. Levels and bases of tax relief are subject to change.
- This material is for general information only and does not constitute investment, tax or legal advice. You should not rely on this information to make (or refrain from making) any decisions. Always obtain independent, professional advice for your own particular situation.