Redefining risk for income investors

An equity-based investment fund that aims to deliver dependable income is likely to deviate significantly from the Australian share market index. It requires an active approach to manage a set of very different risks.

For a typical return-seeking equity fund aiming to outperform the index, the main risk is ‘relative risk’ associated with the portfolio deviating from the index and underperforming this benchmark. But what really matters for income investors is the risk that the fund does not deliver a sustainable and growing income stream.

A different set of risks requires a different approach.

Risks specific to the income investor

Income investors face several unique risks that are often not acknowledged in traditional investment literature:

1) Income level risk

Typically, income investors aim to generate an income stream that enables them to maintain their standard of living. This is a critical issue for retirees, and to achieve this goal they must tackle income level risk – the danger that the income paid by an investment falls in response to interest rate changes and other factors.

In today’s lower interest rate world, term deposit investors need to invest larger sums of capital than historically to achieve the same dollar return. Additionally, these lower rates impact the level of return available from annuity type products and create significant challenges to overcome.

2) Inflation risk

Inflation risk refers to the risk that the real value of an income stream declines as the cost of living rises. For investors to be able to maintain their spending power and to protect, as well as maintain, their living standards they must ensure their income stream grows at least in line with inflation. This is particularly important for people in retirement as they are likely to incur increased costs in areas such as healthcare and aged care services.

To illustrate inflation risk, imagine investing in a term deposit that has an interest rate of 2% p.a., when inflation is compounding at 2.5% annually. In this scenario, even though an investor is earning a nominal return of 2% a year, inflation is eroding 2.5% of that, leaving the investor with a real (inflation adjusted) return of negative 0.5%.

Given retirees will usually have a relatively fixed capital base, inflation protection has to be a central consideration in any medium to long-term income oriented financial plan.

Legg Mason Asset Management Australia Ltd (ABN 76 004 835 849 AFSL 240827) is part of the Global Legg Mason Inc. group. Any reference to ‘Legg Mason Australia’ is a reference to Legg Mason Asset Management Australia Limited. Martin Currie Australia is a division of Legg Mason Asset Management Australia Limited The information in this article is of a general nature only and is not intended to be, and is not, a complete or definitive statement of the matters described in it. The information does not constitute specific investment advice and does not include recommendations on any particular securities. Legg Mason Australia nor any of its related parties, guarantee the repayment of capital, rate of return or performance of any of the Legg Mason Funds referred to in this document

Source: Legg Mason and Martin Currie Australia

The real risk/return trade-off for income investors

For the reasons outlined, investors seeking income need to focus on specific income solutions that can generate a yield high enough to meet their requirements today, that is sustainable over the long-term, that can be expected to grow at least in line with inflation, whilst also protecting their hard-earned capital base.

3) Income volatility risk

Investors worry about movements in the capital value of their investments but for income investors, we believe it is more important to focus on the volatility of the income stream. Putting this a different way – what matters most for income investors is that their investments deliver a sustainable and growing income stream – and the main risk they face is that it does not.

For income-oriented investment solutions, reducing the volatility of the income stream in search of reliable income delivery should be a primary consideration. Data suggests that the actual volatility of the income stream from term deposits is more than double the volatility of the dividend stream from Australian equities. In addition, the income from dividends has been materially higher1.

4) Longevity risk

Australians are living longer. The average life expectancy of Australian men and women is now over 90 years, having increased by an average of around 20 years since 1960. So, the probability (risk) that we outlive our savings is growing – this is known as longevity risk.

And not only are we living longer but more and more of us are entering retirement.

Over the next 40 years Australia’s population will experience a major shift – a far greater proportion of the population will be older – as the dominant baby-boomer generation moves into retirement, and these older Australians will be living longer. This combination will significantly increase the nation’s pension expenses and upset the balance between retirees and the working age people who are funding the pension system. Currently, for every person aged 65 and over there are 4.5 people of workforce age (15 to 64) contributing their taxes to help fund pensions. This is forecast to decrease to around 2.7 people per retiree by 2055, putting an increasedstrain on the entire system2.

1 Source: Martin Currie Australia, Factset, as at 30 June 2018

2 Australian Department of Treasury, 2015 Intergenerational Report, Chapter 1