At first glance, investors seeking regular income could be forgiven for being drawn to strategies offering the highest payout target. Yet, it’s not quite as simple as ‘the higher the better’. As with any investment, it pays to scrutinize exactly what is driving distributions; more reward is likely to be contingent on more risk.

It doesn’t matter how attractive a headline yield looks on paper, either. If it stays the same while the value of the underlying portfolio falls, an investor will automatically receive less income. In most cases, investors would do best to aim for a payout that meets their actual income needs, rather than maximising yield at all costs. This is particularly true in uncertain market environments, when it’s even more imprudent to take unnecessary risks.

Paying dividends

Some income strategies have a total return approach, rather than focusing solely on headline yields. For equities, this typically means investing in high-quality companies with robust outlooks and the potential to grow dividends, which should contribute to a larger capital base and higher income distributions over time. This is important; if absolute payouts are always the same, inflation will gradually erode purchasing power.

This approach might offer a lower yield than a fund which invests solely in companies offering the highest dividends. The risk with the latter is the reliability of the income. A stock on a 6 per cent yield is more likely to cut its dividend in the future rather than increase it (such high yields are difficult to sustain over the long term). And a falling income stream is rarely desirable.

Overreaching for yield?

Another potential drawback of higher income targets is that portfolios can be pushed into increasingly riskier assets to meet their objectives, especially at the wrong time in a market cycle (such as when yields are under pressure after a period of strong capital gains). For example, some bond funds that are ostensibly focused on investment grade assets have ventured into high yield debt, which carries a greater risk of default, as yields across markets have ground steadily lower over the past decade.

The capital question

There are alternatives to adding higher-risk assets to a portfolio. Though, the risks are just different, not removed. Product structures that dip into capital can enhance or ensure the consistency of income payouts. Such approaches have their place; in retirement funding, for example. But they are most effective in rising markets - as we’ve seen over the past few years - when capital can be replenished as quickly as it’s paid out.

However, when conditions do become more challenging and the focus turns to protecting rather than growing capital, strategies that rely on both capital and current income to meet a payout target might look less appealing. The worst-case scenario is one in which an investor opens their portfolio one day to find its value reduced to nothing. How likely this is in reality depends a lot on timing.

Sequence risk

The specific point in a market cycle at which an initial investment is made, as well as the way the market subsequently moves over the investment horizon, influences a portfolio’s capital base as well as its returns; this is particularly crucial for investors dipping into capital to supplement their income. Take an investor with a long-term horizon; if there’s a significant market sell-off at the beginning of the investment, and if payouts are chipping away at capital at the same time, there will be less in the portfolio to benefit fully from a market rebound. The portfolio’s value could shrink a lot more quickly than anticipated.

There is a flipside. It can be prudent to take some capital in steadily rising markets when a portfolio has experienced strong and consistent growth. This means if the market falls late in the investment horizon, it might hurt a little less. Unfortunately, timing markets is notoriously difficult, requiring more luck than skill.

The following chart highlights the impact of sequence risk on a hypothetical multi-asset portfolio comprised of an equal split between Japanese equities and bonds (and assuming a set level of capital attrition). If invested in 1989, just before Japan’s bubble economy burst spectacularly, the portfolio’s value would reach zero at least ten years earlier than if the market’s chronology was reversed.

Source: Refinitiv, Fidelity International, October 2018

Source: Refinitive, Fidelity International, October 2018

Topping up income without lopping off capital

Income payouts can also be enhanced using more complex instruments such as derivative overlays. For instance, selling a call option on a particular stock for, say, 10 per cent above its current price means the money received from the sale can be distributed as additional income. While these strategies do not eat into capital, they still come at a cost since they can restrict the potential for capital growth.

Diversification helps

Whether, as above, it’s less capital growth for a higher regular income, or a lower payout for less risk, investors generally have to compromise depending on both their risk appetite and overall income goals. Which is why a well-diversified portfolio can be beneficial. At an asset class level, bonds, equities, alternatives such as real estate, and even bank accounts or cash-like products can be valuable sources of yield, subject to the prevailing market environment. There are also advantages to allocating across different strategies, combining, for example, lower-risk dividend growth funds with those that enhance income through capital distribution or derivatives.

When it comes to generating a reliable and sustainable income, the first question should be: Exactly how much is enough? And the second: How much (or how little) risk is required to achieve this?