The great income investing myth retirees need to avoid

Australia is in the middle of a demographic shift that will keep demand for equity income growing until at least the 2060s, as a constant flow of Australians move into retirement.

For those retirees and pre-retirees, the question is not simply how to generate income from shares, but how to do so at a level of risk they can live with. It is a conversation playing out across kitchen tables nationwide - and it will be for decades.

One consideration at the heart of that conversation is that the highest headline yield may not always be the path to the most income.

There are different approaches to drawing income from equities in retirement and choosing an approach based on headline yield alone can quietly erode the very capital base a retiree depends on.

These approaches can be broadly understood as a ‘yield approach’ and a ‘dollars of income approach’.

The yield approach

Start with the yield approach. If your goal is income, it seems intuitive to begin with the stocks that pay the most: take the companies listed on the ASX and buy the subset with the highest dividend yields.

Several low-cost ETFs take a broadly similar approach. For illustrative purposes, this article uses one long-established high-dividend ETF managed by a large global manager. The fund holds 50 ASX-listed stocks that offer high dividend yields while meeting diversification, profitability and trading requirements. There is some additional discipline layered on top of raw yield.

It serves as a fair proxy for the yield approach and, as we’ll see, it is the approach that looks the most appealing on day one, but over the period examined, delivered less income than an approach focused on sustainable income growth.

The dollars of income approach

The dollars of income approach starts from a different question, not “what yields the most today?” but “what puts the most money in a retiree’s pocket, year after year, for as long as they need?”

The aim is not to maximise yield in year one. It is to own a portfolio that pays an adequate, sustainable income from the outset while growing both the capital base and the income stream over time.

This is the approach we take with the Lazard Defensive Australian equities approach and the rest of this wire tests the two in a like-for-like comparison, first on risk, then on an important practical measure for retirees: dollars received.

Risk comparison

Start with risk. For retirees, how you earn a return - and the risk you shoulder to get it - can matter as much as the return itself. A retiree drawing down capital cannot simply wait out a deep loss the way a 30-year-old can. Risk can be measured in many ways; I’ll use the two risk factors that investors feel — volatility and drawdown.

First, volatility - the bumpiness of the ride, measured by standard deviation. The chart below plots total return against standard deviation for the yield approach (High Yield ETF, in yellow), the dollars of income approach (Lazard Defensive Australian Equity strategy, in dark blue) and the ASX 200 (in light blue), over the roughly 14 years since our fund’s inception. The difference is notable.

The yield approach took on materially more risk and, over this period, the additional volatility was not accompanied by commensurately higher returns. Investors bore more risk and ended up worse off.

The second measure is drawdown - how much you lose when markets fall, the risk retirees feel most acutely. The chart below takes every negative month for the ASX 200 over the past fourteen years and shows how much of each fall the two approaches absorbed. The results over this period are instructive.

Over the period examined, the yield approach offered investors no meaningful protection, falling roughly in line with the broad market, despite the “defensive” reputation high-dividend stocks often carry. The dollars of income approach, by contrast, consistently cushioned the blow, defending capital far better in the months that hurt.

The main event - income comparison

Now for the main event - income. After all, that is what a retiree lives on. Not a yield percentage, but dollars in the back pocket. The chart below tracks the income received under each approach over the period studied.

Assume $100,000 was invested in each approach in 2012, with all income paid out and spent each year. It shows the dollars an investor received over time, franking credits included, from the yield approach and the dollars of income approach.

This is where the story turns. In the early years there is little to separate them and, just as the headline yield would suggest, the yield approach looks superior at first. But the advantage is fleeting.

Over time, the compounding logic of the dollars of income approach - pairing a sound, sustainable yield with a steadily growing capital base - pulls ahead over the period studied.

By 2025, based on the assumptions and the methodology described, the gap has widened to approximately $4,000 a year, or 4% of the original capital, flowing to the investor. 

Over this historical period, the approach with the higher initial headline yield on day one delivered less income by the end of the period studied; the approach built to grow delivered the most. 

Note: These are historical results for this specific period and illustration only and are not a forecast of future outcomes.

Put the three threads together and the conclusion is instructive. Over the same fourteen years, the dollars of income approach delivered lower volatility, defended capital far better when markets fell, and - the measure that counts most - paid retirees more actual income.

The yield approach won on the one number that retirees are most often sold on, the headline yield, and delivered lower income and higher volatility over the period examined.

That is the case for the dollars of income approach. It will rarely top the table for headline yield in any single year, and that is precisely the point.

This article is intended to encourage investors and their advisers to look beyond headline yield when evaluating equity income strategies.

What the approach is designed to do instead is harder to see at a glance : seek to deliver a sustainable, growing stream of income, while managing risk to get there.

For retirees and pre-retirees, the distinction between headline yield and actual income received can be meaningful. Income is what investors spend; yield is one measure used to assess an investment.

When assessing an income strategy, investors should look beyond the yield advertised in year one and consider the actual dollars received over time, together with the risks taken to generate that income.

Managed Fund

Lazard Defensive Australian Equity Fund

Australian Shares

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