The sharp dividend cuts expected in the UK and globally this year have blown apart the theory of relying on "natural income" in retirement from shares and bonds, with strategies that follow this approach now looking increasingly vulnerable, according to 7IM.
For years, the received wisdom was that buying dividend paying stocks and bonds would enable retirees to leave their capital intact, using only the income from their investments to fund retirement.
However, Matthew Yeates, senior investment manager at 7IM, says this theory - which was questionable prior to the crisis in 2020 - is now at an end.
Globally dividends are being cut heavily this year, and bond yields in the UK are also in negative territory. Anyone relying purely on dividends and bond coupons for income is now facing a big problem."
"Globally dividends are being cut heavily this year, and bond yields in the UK are also in negative territory. Anyone relying purely on dividends and bond coupons for income is now facing a big problem," he says
"Unfortunately, the idea of relying on both in retirement is still very popular, with many investors wrongly advised that this approach 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."
"What's worse is that structured products, which adopt an extreme version of this approach, have become worryingly common as a default solution for retirement income. Anyone in a solution that followed this strategy would have likely got a nasty surprise when they looked at their valuations through March - some funds focussed on this area were down as much as 35% through the period.
"The key difference for investing in retirement is that investors only get one chance to get it right. Following simple strategies, like using natural income and assuming dividends are in some way free, doesn't cut it. Investment solutions for retirement should be built on solid foundations that don't do their worst in large drawdowns but defined income structure products usually do exactly that, which is just plain dangerous!".
One solution to tackle this - and one that is more prevalent than ever given the headwinds facing markets - is to stop splitting capital growth and income up, Yeates said.
"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," he said.
"It can be 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."
Yeates says a total return mindset in retirement, albeit it one which makes provisions for short-term income needs, provides a better long-term solution that doesn't need to be changed or "rescued" when markets tumble.
"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 aim to provide for short-term income needs, longer-term needs, and as 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. This approach allows us the flexibility to look across all types of investments, not just those with high levels of ‘natural' income. In turn, it can help to give 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."
2.5% widely expected
Basic state pension increased 41% since policy inception