Dividend cuts and deferrals reinforce the dangers of overfocussing on yield.

The Australian Prudential Regulation Authority (APRA) recently wrote to Australian banks asking them to defer decisions on dividend payments and suggesting that where payouts occur they be at “materially” reduced levels. This has further compounded investor uncertainty brought on by the COVID-19 financial markets turmoil, but this need not be the case.

Bank earnings are likely to experience pressure with the potential increase in bad and doubtful debts on the horizon and the materially lower appetite for consumers to borrow.

APRA’s request to reduce dividend payments could help shore up capital positions and strengthen a bank’s ability to weather the economic impact of the pandemic. This could even be in the long-term interests of not just the financial system but also shareholders, because a company’s financial health is critical to future share price performance.

APRA’s comments will no doubt leave many retirees – particularly those who use the popular income-oriented strategy to fund their retirement – in limbo about what to do with their portfolios.

Income investing

An income-oriented strategy involves constructing portfolios of investments that have high-income returns that either meet or exceed spending needs. These include shares that pay healthy dividends, especially when they have franking credits attached, and high-interest bond and cash products.

This strategy is also appealing because it suggests that by only spending the income paid, the underlying assets are not touched – which means the strategy should last forever, or at the least, outlast your retirement.

Although this strategy conveniently provides a high-income return, it certainly is not the only strategy or indeed the most effective one to follow. The proposed changes to dividend imputation rules in 2018 highlighted one of the potential risks a concentrated, high-income portfolio may be exposed to. The current market conditions highlight another.

Keeping these risks in mind, an investor might reasonably ask, how do I choose a retirement income strategy that will support my lifestyle but not create an over-reliance on income such as dividends?

This is where the total return approach – a strategy that looks at all sources of returns from your portfolio, both income and capital – comes in handy. A total return approach first assesses an individual or household’s goals and risk tolerance, and sets the asset allocation at a level that can sustainably support the spending required to meet those goals.

Unlike an income-oriented strategy that generally utilises returns as income and preserves capital, the total return approach encourages the use of capital returns when necessary.

During times when the income yield of a portfolio falls below an investor’s spending needs, the capital value of the portfolio can be spent to make up the shortfall. As long as the total return drawn from the portfolio does not exceed the sustainable spending rate over the long term, this approach can smooth out spending during inevitable volatile times for markets.

Of course, it may also require the discipline to reinvest a portion of the income yield when the income generated by the portfolio is higher than the sustainable spending rate.

Power of long-term investing

It should be noted that while capital returns – best represented by the price movement of shares – can be a volatile component of this strategy, taking a long-term view is paramount.

The total-return approach allows you to separate your spending strategy from portfolio strategy. In addition to the benefit of smoothing spending throughout retirement, it can allow for the better diversification of risk across countries, sectors and securities, rather than skewing the portfolio to a segment of the market with higher income yields, or worse, taking excessive risk by reaching for the desired yield.

The riskier approach is often a far less reliable response to achieving retirement goals compared to other levers such as saving more or adjusting discretionary spending.

By taking a long-term view you will also likely ride out periods such as the COVID-19 pandemic with more confidence. History has shown that even in retirement, an investor’s time horizon can be several decades, and sufficient time for the equity risk premium to win through.

Although dividend yields may fall, the valuations on shares have improved as a result of market falls and increased the long-term return prospects for capital values. This is why APRA’s request should not cause further anxiety during this time, even if you are an income-oriented investor.

Finally, and recognising that this can be an uncomfortable position for many, a further action to improve long-term portfolio prospects is to be aware of the inherent uncertainty in trying to time markets, and the improvement in returns that comes from a market sell-off.

In combination, these factors support the merits of rebalancing your portfolio during volatility to ensure you remain well positioned for the eventual turn in the market.