The great big natural lie

Organic. Free range. Natural. When I see these words on a weekend brunch menu, I know two things — I’m expecting high-quality produce… and I’m going to pay for it! Most of us regard natural food as unequivocally good – with no additives or preservatives or anything unexpected.

‘Natural’ means “not made or caused by humankind”. It seems absurd that the idea should be applied to anything in finance, which is created entirely by humans. And yet time and time again we hear about ‘natural’ income, as the media and investment managers push high-dividend stocks and income-focussed funds.

But, despite what many believe, ‘natural’ doesn’t automatically mean quality. And it certainly doesn’t mean guaranteed. Buying a stock just because it pays a high dividend is a weak investment strategy. If the managers of a business think their shareholders would be better served by cutting the dividend and reinvesting in the business, they have every right to do so.

Then of course, there are external events that impact the payment of dividends and reminds us that ‘safe’ dividend-paying firms are not necessarily safe at all. Unsustainably high dividends usually end up being cut – as we’re seeing now in the current coronavirus climate. Sometimes they even disappear altogether.

In the UK, some of the largest payers historically have been banks and oil companies. Just last week we wrote about how HSBC suspended its dividend for the first time since the Second World War, with all other UK banks following suit. And the oil companies aren’t much more reliable – plunges in the price of oil aren’t good for pay-outs to shareholders!

In some cases dividend payments from entire countries are being halted, like in France and Germany. For investors with a long term time horizon this looks like an investment opportunity, but if you were relying on those dividend payments for income this year, you’re out of luck.

Income in retirement

When people investing for retirement stop working, suddenly they have a new investment need, a new goal. Rather than accumulating wealth and trying to maximise the size of their nest egg, they want an income to live from that will last.

Investors looking for a portfolio that maximises their chance of meeting their retirement spending needs should not view income assets and capital growth assets as separate things. It’s better to focus on the total return of portfolios, incorporating both capital returns and income. After all, income can be created by selling the proceeds of capital growth just as easily as from ‘natural’ dividend payments.

So why do people follow the natural income approach? The most common answer is that focussing on the dividends of investments “leaves the capital intact”. One of the best kept secrets in finance is that this statement is absolutely, 100% not true. Assets that pay an income (e.g. when a stock pays a dividend) drop by the value of that dividend on the day that payment is made, i.e. the capital isn’t left intact at all. People often don’t realise this, simply because the size of the individual drops is so small.

At 7IM we believe in a long term, total return approach to retirement income. To allow us to take a long term approach we split investments into different pots that provide for short term income needs, longer term needs and a buffer to provide income when periods of volatility arise. We have rules in place to follow for rebalancing portfolios when markets are up or down. We have built systems to test those rules through periods like the last few weeks and much worse, covering thousands and thousands of different potential outcomes.

This approach allows us the flexibility to look across all types of investments, not just those with high levels of ‘natural’ income. It allows retirees the flexibility to work out how to spend their total return in retirement, without worrying that they’re getting a little less this year from dividends.