High yield vs other investing strategies

[JohnB]

I'm surprised that no-one has mentioned that the goal of living off dividends that leads you down the HYP path excludes that fraction of the market that rewards you with capital growth. Not only can it be unwise to avoid a market segment, you are also accepting income tax on dividends and not taking account of the extra allowance, and lower tax rate on capital gains.

I'd say a better target would be to live off Total Return from a portfolio, and accept that would include selling a fraction every year (well selling more, and buying back most, as you use your CGT allowance)

[Gengulphus]

... and not taking account of the extra allowance, and lower tax rate on capital gains.

The extra allowance effect can work both ways - I for instance would not have any use for a substantial part of my personal allowance if I didn't have dividend income. So can the tax rate: for a basic-rate taxpayer, the tax rates are 7.5% on dividend income and 10% on capital gains. And there can be big reliability and work-put-into-the-investments differences between the two... I will agree that those differences can basically be eliminated by the use of suitable funds - but funds come with management fees, which would be very well-spent if they were rewarded with superior performance, but all too often they aren't. And as recipients for my investments' earnings, I see little reason to prefer either of the taxman or an undeserving fund manager over the other!

It is doubtless a one-sided comparison for those with particular financial circumstances and preferences - but it's not one-sided in general.

Gengulphus

[IanTHughes]

I'm surprised that no-one has mentioned that the goal of living off dividends that leads you down the HYP path excludes that fraction of the market that rewards you with capital growth. Not only can it be unwise to avoid a market segment, you are also accepting income tax on dividends and not taking account of the extra allowance, and lower tax rate on capital gains.

I'd say a better target would be to live off Total Return from a portfolio, and accept that would include selling a fraction every year (well selling more, and buying back most, as you use your CGT allowance)

Anyone contemplating this Drawdown Strategy - supplementing Income with capital gains - should be sure what they will do in the event that there is a capital loss? Does one simply sell more capital at the lower prices or does one suspend capital sales until growth returns?

Also, the sale of capital that is producing income will necessarily reduce future income which means that more and more capital must be sold each year, even without capital losses. How does one ensure that he capital that is now relied upon to pay the bills in retirement will last?

Without resolving the foregoing, capital drawdown to provide income in retirement is a very dangerous strategy in my view


Ian

[JohnB]

Say your portfolio returns 3% dividends, and 1% capital gain over inflation, averaged over a decade. You could just take the dividends, but you'd be getting richer and be short of income, which seems odd.

A drawdown scheme aims to reduce your portfolio to low levels at death, a wealth preservation one to pass the money on, but neither is served by not spending capital growth.

Obviously you should balance your withdrawls with the vagaries of the market, both in dividend and capital fluctuations, but if you rigidly refuse to spend capital, you will need a much bigger pot to start with, and die too rich.

HYP strategies might focus on a market segment that returns 3.7% dividends, 0.3% capital growth, but they should still consider that growth, and be conscious that they are missing out on some market diversity, and the lower costs/admin burden of trackers that cover it all.

[BrummieDave]

I read this last night following a link from 'Moneyvator' and it's an easy-read, good summary with, as ever, interesting readers comments: http://www.theretirementcafe.com/2019/0 ... to-be.html

[Itsallaguess]

I'm surprised that no-one has mentioned that the goal of living off dividends that leads you down the HYP path excludes that fraction of the market that rewards you with capital growth.

Not only can it be unwise to avoid a market segment, you are also accepting income tax on dividends and not taking account of the extra allowance, and lower tax rate on capital gains.

Are you suggesting that high-yield investments don't exhibit capital growth?

That's certainly not been my experience, and whilst capital-growth isn't seen as a primary objective of most of the prominent high-yield strategies discussed around here, I can certainly tell you that I usually have plenty of opportunities to make use of some of my CGT allowance each year.

Capital growth might be a by-product of mainstream high-yield strategies, as opposed to their primary aim of providing the bulk of returns via dividends and dividend-growth, but there's certainly no evidence that people would be 'excluding' the potential reward for capital growth by following such strategies...

Cheers,

Itsallaguess

[JohnB]

I'm saying the reverse, anyone with a portfolio will have capital growth they need to manage and benefit from. Hence don't just plan to "live off the dividends".

Do HYPers keep rebalancing to keep their capitalisation-weighted portfolio consistent, or buy-and-hold and let the capital value of their holdings diverge, happy that the dividends are not.

[Itsallaguess]

I'm saying the reverse, anyone with a portfolio will have capital growth they need to manage and benefit from. Hence don't just plan to "live off the dividends".

Well you said that people looking for dividend income would be unwise to avoid a market-segment that gave capital growth, which is the point I was refuting as it's not been my experience. I've had plenty of opportunities to enjoy capital growth whilst owning high-yield shares, so by doing so I would not at all consider myself to be 'avoiding' capital growth at all....

Do HYPers keep rebalancing to keep their capitalisation-weighted portfolio consistent, or buy-and-hold and let the capital value of their holdings diverge, happy that the dividends are not.

Well given that we're on Strategies here, I can tell you that this HYPer rebalances when an opportunity arises to do so, and tries to maintain balance by managing my purchases and top-ups to help with that task - both of those approaches seem to work well, and have done so for many years. I'm still in the building-stage, so I appreciate that this is an easier thing to manage than if I were already taking my income, which might well remove some of the opportunities to mange such re-balancing due to the potentially lower number of purchase or top-up opportunities..

Sometimes a high-yield investment might produce a level of capital-growth that hasn't been matched in a similar way to the dividends that the particular investment might be producing, which means that a situation is sometimes produced where, for example, an investment that was originally bought on a yield of 4.5% might have a level of share-price growth that perhaps means that a good level of capital-growth might occur over a period of time, but because of the lack of dividend progress during the same period, it might only be yielding, say, a 2.5% dividend yield now.

In circumstances like the above, I'm often quite happy to at least top-slice, and sometimes sell out of completely, the original holding, and rotate some of that released capital into a higher-yielding income-investment.

This produces a nice lift in income across the income-portfolio, diversifies away what might be an anomalous capital 'lump' in the portfolio, and makes use of some capital-gains allowance, and I see it as a nice opportunity to take advantage of some of the swirls and eddies that are produced in our income-investments by the market sometimes...

Cheers,

Itsallaguess

[bluedonkey]

I cannot understand most of what Pastcaring is writing.

Me too. It's a struggle to decipher it.

[tjh290633]

I'm saying the reverse, anyone with a portfolio will have capital growth they need to manage and benefit from. Hence don't just plan to "live off the dividends".

Do HYPers keep rebalancing to keep their capitalisation-weighted portfolio consistent, or buy-and-hold and let the capital value of their holdings diverge, happy that the dividends are not.

Most HYPs will not be capitalisation-weighted, they will be approximately equal-weighted. Personally I take steps to avoid going overweight as typified by my trimming of Rio Tinto today, see viewtopic.php?p=213815#p213815

I set weight limits to not more than 50% above the median holding value. Others may use twice the median or average and some may use 10% of the portfolio value.

The object is to reduce the risk from any one share going belly up, which you cannot avoid in a sudden collapse.

TJH

[Gengulphus]

Say your portfolio returns 3% dividends, and 1% capital gain over inflation, averaged over a decade. You could just take the dividends, but you'd be getting richer and be short of income, which seems odd.

And it's very obviously not a good idea to do your financial planning that way if you're going to be short of income - because the capital growth is not reliable, even over a period as long as 10 years. For instance, imagine that the portfolio concerned holds a FTSE 100 tracker. Some selected FTSE 100 values, for April 9th or a close trading day if it fell on a weekend (April 9th was the day I wrote this bit of the post - it's been sitting around unfinished for a while! And the 2019 value is an intraday one, while the others are at the close):

1994: 3120.8
1999: 6472.8
2004: 4489.7
2009: 3983.7
2014: 6635.6
2019: 7455.4

Those indicate that the annualised capital growth rates over the 10 years covered are:

1994-2004: +3.7%
1999-2009: -4.7%
2004-2014: +4.0%
2009-2019: +6.5%

What's it going to be over the 10 years to 2029? Based on that data, I have no real idea... And while one can find all sorts of predictions about such things if one looks for them, I very much doubt that those who make them have any real idea either!

Even looking at the couple of 20-year periods those figures cover, the annualised rate for 1994-2014 is +3.8% and that for 1999-2019 is 0.7%, so pretty significantly different from each other. That's up in the rough area of the typical lengths of time people live in retirement, so while one might get a better estimate of the long-term capital growth rate by looking at yet longer periods, that isn't very relevant to the fundamental unreliability of capital growth for most practical planning about living off one's investments.

Dividends aren't all that reliable either, of course. My HYP's dividend income reduced by about a third between the 2008/9 and 2009/10 tax years, tjh290633's reduced by about a half. That was a very unusual year's change, but there is a risk of something like that happening again. And unless you plan to be able to live on quite a lot less than the portfolio's dividend income and/or have a good-sized reserve of cash to supplement a shortfall in dividend income, you have to have at least a contingency plan to sell part of the portfolio if the dividend income is doing badly enough.

There is a major drawback to all such plans, which is that the stockmarket tends to be low when dividend income is low and high when it is high. So the times that you're especially short of income and so particularly need to sell shares to make up the shortfall are also the times when you can't get all that much more for them, and so will have to sell a particularly large number of them. And if your plan also then involves buying at times that you have dividend income surplus to what you planned on, to restore the dividend income to its expected level, share prices are likely to be high at the time, so that you'll get relatively few shares. I.e. such plans have a somewhat hidden Buy High, Sell Low aspect to them - not a desirable feature of an investment plan!

But having such a feature is basically unavoidable, at least on a contingency basis if things go sufficiently badly for sufficiently long, so all one can do is try to make it as small a feature as possible. In particular, plans that only involve selling shares on an if-things-go-sufficiently-badly contingency basis, rather than routinely, fairly obviously have a smaller component of it. And that's basically where planning to use only the dividend income of a HYP to live on comes into it - and in fact, especially for someone who is retiring early, I would recommend planning to use less than the dividend income of a HYP to live on, and use the surplus income to cushion dividend cuts as necessary, to build up a good-sized cash reserve, to grow the HYP to be yet bigger so that you can withstand an even worse period of dividend cuts, and/or for 'bonus' spending that you can cut back on if and when necessary. The exact mixture of those uses depends too much on personal circumstances and preferences for me to be able to say which any particular HYPer should choose, but give serious consideration to the consequences of the high unreliability of capital gains, and to those of the lesser but still very significant unreliability of dividends when doing the planning. They mean that any future projections of one's financial future should not be based on average cases, but on a scenario which is highly likely to be exceeded.

Also, that principle needs to be extended to one's expected remaining lifespan. In particular, suppose that you're 60 when you want to retire and you check up on your expected remaining lifespan and get an answer of 20 years (in the right ballpark, but I haven't checked the exact figure). So you decide to go for a capital drawdown scheme that aims to reduce your portfolio to a low level (as close to zero as possible) in 20 years' time. Knowing the unreliability of all returns from equities, you instead put your capital into bank deposits, gilts or other investments with highly reliable returns. A good plan? Well, no - not unless you want to take a roughly 50% chance of running out of money at age 80 because you happen to be one of the roughly half of people who turn out to live longer than statistically expected. Maybe that's a risk you're happy to take, but if I were to use a capital drawdown plan, I would want to do my planning on the basis of the age that I'm at least 90% likely to die before reaching (which is probably somewhere in the 90-95 range) - and I'd prefer 99% or even 99.9%! That pushes the number of years a capital drawdown plan needs to cater for up quite a lot, which means that if one uses such a plan, one will probably actually die with quite a lot of capital still intact. But basically, because of the uncertainty of the age one will live to, one can trade off the risks of dying with unspent capital and living destitute & very old off against each other: one can reduce either a long way, but only at the expense of increasing the other significantly. And I know which of those risks I'd prefer to take!

Returning to HYPs after that excursion into investments with much more reliable returns, the real question is what withdrawal rate it's prudent to use in one's planning. I've found a very useful free tool to use in such planning is FIRECalc - it's got its limitations for me and for HYP purposes, especially the fact that it's US-based rather than UK-based, doesn't allow one to choose what types of equities one invests in, and doesn't distinguish between dividend income and realised capital gains, but it does have the advantages of being based on real-world data and allowing one to see a good range of outcomes from a scenario rather than just the average outcome. Their default scenario of $750k capital, £30k income (inflation-adjusted) taken for spending (so an initial 4% withdrawal rate), 30 years to go (in the "Start Here" box on the right hand side) is quite instructive: if you click on its "Submit" button, you'll get a set of numerical statistics about the 118 30-year periods in their data. The average final portfolio value (also inflation-adjusted) is $1,395,451, which is about a 2.1% annualised real capital growth rate over 30 years. So just looking at the average outcome suggests that one might reasonably expect to be able to take withdrawals that are initially 4% of one's capital and rise with inflation, and still see one's capital rise in the long term, and one might naïvely decide that a plan based on doing that was pretty obviously on solid foundations.

But when one looks at the statistics of the 118 individual outcomes, 6 of them run out of money in the 30-year period, and looking at the chart as well, one can see that the first of those did so in year 24. It's fairly clear (at least to my eye) that quite a few over half of the lines end up below the ~$1.4m average - the average is pulled up by the fact that a few of the best 30-year periods do very well indeed, with the best line ending at over $4m. And it's also fairly clear that several more of the lines have got so low that they're heading inexorably towards running out of cash - which one can confirm by changing the period to 40 years and rerunning. The number of run-out-of-money periods rises from 6 out of 118 (5.1%) to 16 out of 108 (14.8%) - which at least for me would be a move from a rather uncomfortably high chance of ending up old and destitute to a very uncomfortable chance of it. Though of course, how relevant that change is does depend on one's age: the chances of living another 40 years are very low indeed for a 65-year-old retiree, but rather higher for a 50-year-old early retiree. (One can combine the figures with longevity data so as to assess the combined effect of equity uncertainties and date-of-death uncertainties somewhat more definitely, which is something I did back in 2010 for this TMF post, but that takes quite a bit of careful work - more than I'm going to tackle at present!)

The net result of all that is that FIRECalc suggests that a 4% withdrawal rate can easily be uncomfortably high, though whether it actually is will depend a lot on the HYPer's age and preferences about just how far they want to drive down the risk of ending up old and destitute. And I don't think I've ever seen a HYP designed that had a portfolio yield below 4% - individual holding yields below 4%, yes, but not the overall portfolio yield. So in practice, if you want to run a HYP and take an initial 4% income from it, you can easily do so from the dividend income alone - no need for share sales to boost a 3% dividend yield up to the 4% you'd like, and if you were to make the share sales anyway, you'd just have to decide what to do with the surplus cash. And in fact, you're probably going to be getting such cash in the form of surplus dividend income anyway and having to decide what to do with it...

One other point to take into account: the FIRECalc graph and its wide range of outcomes suggest that just taking an inflation-adjusted constant income is ultimately likely to end up in a vicious circle of reduced capital producing reduced returns, meaning more capital has to be taken out with sales and so yet further reduced capital, or in a virtuous circle of increased capital producing increased returns, meaning there's yet more surplus income to reinvest to increase capital yet further. And if you increase the period to e.g. 100 years (as a thought experiment, of course - it's not feasible for individuals in practice!), it becomes apparent that that really is what's going on - virtually no lines in the resulting chart end up near an inflation-adjusted $750k, but instead about a quarter of them have ended up in the vicious circle and have gone strongly negative, while the other three quarters have ended up in the virtuous circle and have inflation-adjusted values far above $750k. The point is that if one sees that one has got into the virtuous circle, one can easily cut back on its dying-with-unspent-capital effect by awarding oneself a higher-than-inflation 'pay rise', but if one sees that one has got into the vicious circle, that's much harder to break out of - and very conceivably impossible to do so, leaving one watching one's capital inexorably draining away and merely able to wonder which of capital and life one is going to run out of first... I.e. the vicious circle is a trap, the virtuous circle isn't, so for me at least, it's much more important to avoid straying into the vicious circle than into the virtuous circle.

So to summarise the main points of the above:

* Future capital growth is very unpredictable, even over periods of 10 years and more. (If one needs to cash in on it or be "short of income", one is actually probably short of capital!)

* Dividends are also rather unpredictable, but not as unpredictable - so it's only prudent to rely on rather less from them than your portfolio can produce. (In particular, one can very safely predict that they won't go negative - which is not the case for capital growth, even over 10 years...)

* Good financial planning for retirement income needs to involve taking all that unpredictability into account by making a serious attempt to look at the range of plausible outcomes, both for one's investments and one's lifespan, not just look at the average case.

* While some types of equity investment strategies do have a lower dividend yield than a safe withdrawal rate, and so need the dividend income supplementing with sale proceeds if one is going to withdraw at that rate, HYP strategies have significantly higher dividend yields that may well be (and IMHO probably are) above the safe withdrawal rate.

* If one wants to keep the risk of running out of capital before one dies down to a reasonable level, plan for living considerably longer than one's statistically-expected remaining life expectancy. In particular, this affects how long any capital drawdown planning one does should assume one is going to live, making it a lot longer and so making the amount of capital it is reasonably safe to draw down per year a lot smaller. Just how much longer that should be depends on one's age and how big a risk one is willing to take, but think in terms of at least a decade longer.

* Erring on the high side about how much capital one leaves oneself with is easily corrected. Erring on the low side is not!

Gengulphus

[JohnB]

A good review. I think people do focus on income modelling to the detriment of expenditure modelling. With the welfare state providing a backstop, destitution is not going to happen, but everyone needs to think what level of spending constitutes the good life, the OK life, and the bad life. On a virtuous spiral, spend for the good life, but at signs of a death spiral switch to OK life to avoid bad. Depending on your taste for luxury, that could halve your expenditure, and after tax breaks be a 60% drop in income.

Expenditure modelling tends to forget big one-off items, weddings, new roofs etc, and some of those can be postponed to the fat years.

[TUK020]

I see a lot of discussion about safe withdrawal rate from a high yield portfolio, which always seems to get simplified over one point.

When comparing with an annuity for example, the thing that one needs to look at is not an hyp in isolation, but an hyp + cash buffer combination. This reduces the reported return/dividend rate from the the overall pot.

If one were to start with an intended income of 80% of the dividend yield, and 1 year's worth of intended income cash buffer.
Only increase the intended income when the cash buffer has grown to 2 year's intended income, and make sure the dividend covers the new amount.

This makes it much easier to massively reduce sequence of returns risk, but makes comparison very complicated

[Steveam]

This so depends on one’s ambitions but Gengulphus’ post is excellent. Expenditure modelling is also very hard if one’s looking at a substantially different lifestyle (so not a projection of today’s expenditure). I have friend whose wife has become very frail: after hospitalisation she is now in a very nice convalescent home but it’s costing £1000 a week and likely to go on for 3 or 4 months.

A cash (or equivalents) buffer is an absolute necessity. I’ve set this as 4 times annual expenditure to avoid (any) risk of having to sell when prices are depressed but this is set so high because a) I’m almost entirely equities invested b) I can afford to have a large cash buffer and still have an income substantially above my expenditure (so I’m still saving) and c) I have very little other income such as pensions (I’m deferring the state pension which is effectively an annual purchase of a deferred index linked pension but I’m aware that there is political risk with this).

And on a lighthearted note: reach 90 and buy an index linked pension ...

Best wishes,

Steve

[scrumpyjack]

I read this last night following a link from 'Moneyvator' and it's an easy-read, good summary with, as ever, interesting readers comments: http://www.theretirementcafe.com/2019/0 ... to-be.html

Of course the point that the article about dividends misses completely is that (in theory at least!) the directors of each company you have shares in are making a judgement each year about how much they can pay out in dividends and still the leave the company able to carry on growing and investing.

By spending those dividends, but not spending capital by selling shares, you are going along with their judgement on how much you can spend whilst still preserving and enhancing your capital.

Of course in reality many companies pay out too much in dividends because their management cannot bear the disgrace of cutting the divi.

But also other companies continue to be very prudent in determining dividend levels so that the company has more cash to invest in growth.

There can be a danger with the HYP approach that you end up investing too much in the former types of company.

[Alaric]

There can be a danger with the HYP approach that you end up investing too much in the former types of company.

Particularly as the proponents encourage investors NOT to monitor total return by proposing to ignore capital values. But how do you determine the difference between a Company like Tesco where the dividend cuts following their accounting scandal are now being reversed and ones like Carillion or Interserve that with the benefit of hindsight were on the verge of collapse, even whilst maintaining a dividend?

[Itsallaguess]

Of course in reality many companies pay out too much in dividends because their management cannot bear the disgrace of cutting the divi.

But also other companies continue to be very prudent in determining dividend levels so that the company has more cash to invest in growth.

There can be a danger with the HYP approach that you end up investing too much in the former types of company.

Those former types of risks aren't exclusive to high-yield investing though....

We only need to look at some of the 'growth at any cost' failures over the years to see that 'management-excess' is an investment-risk, and not just a high-yield-investment risk.....

Anyway, this is where the P in HYP comes in, as a good spread of income-investments across a Portfolio of diverse companies and sectors will hopefully mitigate some of this inherent risk, or at least stagger the emergence of such issues in terms of when these issues might strike, and how much impact any given issue has on our income-streams in any given period..

With that said, this is also a reason that I've moved a large section of my income-investments into high-yield Investment Trusts. Whilst I might find my income-portfolio yields slightly less than some of the yield-figures available via single-company HYP portfolios, I find that the wider diversification of the income-IT's, along with the in-built income-reserves that these Investment Trusts often hold, gives me much less of an exposure to such individual-company risks and potential impact in this area.

But I think it would be a mistake to think that the risk of management largesse only exists with regards to income-investment strategies - it's likely that boardrooms across the investment-strategy spectrum are little different to one another in that regard...

Cheers,

Itsallaguess

[monabri]

And on a lighthearted note: reach 90 and buy an index linked pension ...

Steve

I wish to take you up on THAT offer...especially reaching 90

[Alaric]

But I think it would be a mistake to think that the risk of management largesse only exists with regards to income-investment strategies - it's likely that boardrooms across the investment-strategy spectrum are little different to one another in that regard...

I think one should be critical of stock selection approaches that ignore the possibility that the dividend is in effect just a return of capital. A recently selected stock in a "HYP" example portfolio has already shed something like 5% or more of its supposed 9.5% yield by way of capital loss. Particularly if intending to adopt a "buy and hold" strategy, for those stocks where the dividend yield is too high to be true, it probably is in total value terms.

[Itsallaguess]

But I think it would be a mistake to think that the risk of management largesse only exists with regards to income-investment strategies - it's likely that boardrooms across the investment-strategy spectrum are little different to one another in that regard...

I think one should be critical of stock selection approaches that ignore the possibility that the dividend is in effect just a return of capital.

A recently selected stock in a "HYP" example portfolio has already shed something like 5% or more of its supposed 9.5% yield by way of capital loss. Particularly if intending to adopt a "buy and hold" strategy, for those stocks where the dividend yield is too high to be true, it probably is in total value terms.

You won't find any argument from me there - although I think we should be careful when suggesting that a particular selection-strategy 'ignores' something, especially when those stock-selection strategies might well contain other (non-yield..) pre-selection filters that we might consider to be useful in weeding out some of the worst examples of poor underlying businesses that simply can't maintain the levels of dividends that we might currently be considering.

I think the HYP approach goes some way to fulfil that approach, with it's basic sanity-checks in terms of payment-history, debt, dividend-cover etc., although I will also totally agree with you that these issues often come to light when we're considering 'too good to be true' yields, so again, you'll hear no argument from me with regards to those issues either, as I take the same view with my own HYP as you're warning against, and don't tend to 'chase yields' in anywhere near the same way as I did when I first started out with my high-yield investment.

Cheers,

Itsallaguess