Retirees seek regular income of approximately 4 per cent to meet their annual spending requirements; they understand taking income above that level is likely to result in capital erosion. 
On the whole, the return available from balanced mandates has made this a sensible expectation that has been met in recent years. Since the 2008/9 financial crisis, cash rates have fallen and remain close to zero whilst bond yields have collapsed, thereby forcing retirees into alternative ways of generating the required income.
Even as recently as 2010, high-quality government bonds offered a reasonable income yield with relatively low risk, and therefore provided a viable income solution. By 2013, however, the continued fall in government yields made it necessary to complement government bonds with substantial allocations to high yielding corporate bonds.
Fast forward to today and the situation is worse still; despite below trend economic growth, the global hunt for yield has further compressed yields in low risk and high-risk assets alike, with many government bonds now offering negative yields. Regardless of whether they provide large, unexpected capital gains, it is impossible for government bonds to provide sufficient income to meet the above requirements, even if duration extension is considered. This leaves only junk bonds and high yielding equities as providers of genuine income.
Investor behaviour can compound the problem
While higher volatility is typically associated with higher ultimate returns, in practise this is not always the case. In particular, it is very difficult to maintain a long-term investment horizon during periods of portfolio weakness.
Experiments have suggested that losses are felt about twice as much as equivalent gains and therefore investors tend to prematurely panic out of loss making positions. This loss aversion tends to be more damaging with expensive and/or high volatility strategies; it is therefore more likely with current (higher risk) income seeking portfolios than has been the case historically.
After a significant fall in portfolio value, investors are often “forced” to lock in losses and move to a lower risk portfolio to preserve the value of their remaining assets. As markets subsequently rebound from these “fire sale” levels, investors don’t fully participate, leading to a permanent impairment of their capital.
In practice, most retirees build their retirement savings gradually by contributing on at least an annual basis.
A heightened sensitivity to losses in later years has historically led investors to de-risk their portfolios as they approach retirement, usually by switching from equities to fixed income. Given the current level of government bond yields, however, that switch may significantly crimp future potential returns, and increase the risk that the fund loses value in real terms.
A similar dynamic is in play in the early years of retirement as the performance of the portfolio in those first years plays an important part in the long-term value of the retirement pool. The effect becomes increasingly important as the distribution rate approaches or exceeds the expected long-term return of the portfolio.
What about balanced portfolios of stocks and bonds?
The ideal investment vehicle around the point of retirement should deliver stable, positive returns with adequate levels of income. Traditional portfolios simply cannot meet these objectives. Even balanced portfolios of stocks and bonds, which offered reasonable yields a few years ago, no longer provide sufficient income. In previous periods of stress, returns from fixed income were boosted by a combination of interest accrual and a fall in yields. Going into the next equity correction, balanced portfolios will no longer have a cushion from the yield on bonds to offset the equity losses, but will need to rely almost entirely on capital gains. Furthermore, a legitimate concern relates to the potential for a break in correlation between bonds and equities; rather than bonds providing stability to a balanced fund in the event of an equity correction, bonds may amplify losses.
An alternative to the balanced fund solution
In recent years, diversified absolute return funds have allowed some investors to accept a combination of income and capital to meet their spending requirements, rather than follow the riskier, pure income approaches. How fund managers achieve this objective varies by fund. Some managers will purchase portfolio protection, whilst others will try to mitigate risk through diversification; most sit somewhere between. An obvious advantage of this tightly risk-controlled environment is that if one can maintain capital whilst others are suffering drawdowns, opportunities emerge to make investments at “fire sale” values.
These same absolute return strategies can also be implemented in ways that generate real, distributable income, while following an identical underlying investment strategy. Whilst maximising income of a portfolio is a legitimate goal, it must be done with a close eye on associated risk. Traditional approaches to income generation, such as cash or government bonds, are no longer viable solutions for income seeking investors. For many years, a simple balanced portfolio offered a reasonable solution but now even this has been compromised. Now, absolute return and diversified multi-asset products can meet the dual demand of return and safety and have evolved to also provide stable income, thereby offering investors a lower risk solution to their income requirements.
Derivatives to enhance income
Call overwriting is a means of further enhancing income by effectively converting a future potential upside into an immediate income stream. Put simply, a call option gives the owner the right, but not the obligation, to buy an agreed quantity of an asset from its seller, at a certain time (the expiry date) and for a certain price (the strike price). Returns are capped above the call strike as the asset gets “called”, but the investor is rewarded with a fixed sum, the option premium, regardless of the asset performance. This leads the strategy to outperform when markets drift higher or correct.
Put writing offers a similar return profile to call overwriting. In this instance, a put buyer has the right to put equity onto the seller and pays the seller a premium for doing so. From the point of view of the seller, they receive a steady stream of income until the equity markets falls and they are delivered equity at lower levels. In effect, it is a strategy that buys equity on setbacks, which has been an effective long-term strategy.
In summary, one can either write calls against an equity portfolio, sell puts against a cash holding or a combination of the two to generate an income stream; historically this has also resulted in an improved risk return profile of the fund. Importantly, during an equity market correction, both the put and call writing strategy will outperform a simple long equity position.
Stephen Crewe is a director at Fulcrum Asset Management. The views expressed above are his own and should not be taken as investment advice.