Where has my income gone? Investing in a low cash rate and low dividend environment
When you focus on the total return of your portfolio, it’s OK to take some capital gain profits and use them for income.
For a long time, it was argued that a “blue chip” Australian shares portfolio supported by some term deposits was all an SMSF member needed when drawing an income stream. The dividend stream from the shares was reasonably consistent and predictable each year, and generally matched the minimum annual pension draw-down in the years post retirement when also factoring in the value of the franking credits. Diversification was also covered by including some companies that derived a reasonable portion of their revenue offshore.
During 2020, as the world economy began shutting down due to COVID, many investors experienced a significant reduction in dividends flowing into their SMSF bank accounts, and unsurprisingly a sense of nervousness began developing around how members would meet their minimum pension payments without dipping into their capital.
Australian companies have always had a history of high dividend-payout ratios, particularly when compared to their international compatriots. This is often one argument for a “home bias” when investing, in that the dividend yield for Australian shares is a lot higher.
Dividends drive up values
It has been suggested that the prevalence of high dividend yields is correlated to the introduction of the dividend imputation system, and the added value to a shareholder of receiving a fully franked dividend. With the introduction of dividend imputation, we saw many retirees begin to focus on high dividend-paying companies as they sought passive income, which in turn drove up the share price, and completed the cycle incentivising boards [nm1] to keep paying out high dividends.
We have also seen specific managed funds established with marketing titles such as “yield chaser” or “dividend harvester” to further get the attention of investors seeking income returns for their portfolio. It is little wonder then that as investors we have become obsessed with income returns in isolation and considered the drawing of capital in retirement to fund living expenses as a failure of the investment portfolio.
“Build your portfolio around a diversified asset class framework rather than picking individual investments”
With lower dividend yields because of falling company profits (particularly banks and financial shares), and cash and term deposit rates at historical low levels (virtually 0 per cent), it is time to adjust your mindset when investing to focus on the total return of your investment portfolio. This approach is not new but does involve a mindset change that requires considering your portfolio from the “top-down”, rather than a basket of isolated parts. In other words, you build your portfolio around a diversified asset class framework rather than picking individual investments.
Sell into strength
The key advantage of diversification is that the various asset classes in the portfolio will behave differently at different times, offering the opportunity to take profits when certain asset classes are doing well, and top up other asset classes that have been under-performing. To make this work, it is important that the various asset classes need to have low correlations to each other.
Using this framework, your cashflow requirements then come from the total return of the portfolio, and should be confined to the interest, dividend or rental income stream. Sometimes this means the cashflow is coming from a mixture of income and capital, and this is OK – so long as the total portfolio return is exceeding the cashflow draw.
Better than the alternative
A total return and top-down diversification approach will also unlock a wider range of traditional investments for portfolio inclusion, such as lower yielding bonds and international shares, as well as Australian shares with low or no dividend yields. These assets can add meaningful diversification benefits, and the potential for higher capital growth.
With investment income levels falling for Australian shares, other alternatives to a total return mindset include cutting expenditure to match your income or seeking out investments that promise higher yields. These approaches don’t sound appealing when you consider that they could lead to diminished standard of living and higher risk outcomes.
Partner & Principal Adviser
Minchin Moore Private Wealth Advisers
Cathryn has over 20 years’ experience in financial services and is an accredited Executive Coach.
In 2015, Cathryn established her own financial advice practice which she merged with Minchin Moore Private Wealth in 2019. She is now a Partner and key decision maker in that practice.
Before moving into financial advice, Cathryn worked in corporate finance and institutional sales roles at a global investment bank and large trading bank.
Cathryn has been a finalist in the AFA Rising Star Awards and sat on ASICs Financial Advisers Consultative Committee. In 2019 she was also named by Financial Standard as one of Australia’s top 50, most influential advisers.