Viewpoint: The trouble with income funds

Six weeks after George Osborne killed the requirement for most pensioners to buy an annuity, financial media is teeming with advice for your newly-liberated pension pot. Most is rubbish.

The recommendations vary but largely suffer the same fatal flaw: they focus on income generation only, ignoring investors' goals, needs and time horizons - and the total long-term returns they need to secure their financial future.

Take so-called income funds, investment companies or unit trusts whose purpose is generating above-average dividend yields. Far superior to annuities with rock-bottom payouts based on gilt yields, say proponents. Fair enough, but only because annuities are rotten. Income funds aren't rotten, but they aren't a surefire ticket to a secure retirement.

The problem with income funds is they focus on dividend yield alone, assuming one must generate retirement cash flows from dividend payouts. The higher the payout, the better. This comes from the age-old myth income and cash flow are the same. False. Dividends are a form of investment income and can be a fine source of cash flow - money you take out of your portfolio. But they aren't the only source or the best one.

Dividend cuts

Dividends aren't guaranteed. Firms can, and do, cut them. Many banks cut their payouts during the financial crisis. BP cut its dividend after the 2010 oil spill in America's Gulf of Mexico. Regulatory and tax changes could prompt more firms to use share buybacks to return cash to shareholders instead of dividends. Funds boasting a 5% or 6% yield today could easily yield 2% or 1% tomorrow.

Dividends are nice, but they're only one component of total return, price return and dividends combined, which is what really matters. High-yield stocks are just one category. They go in and out of favour, just like value and growth. Aiming for yield may also cause you to under-diversify, since high-yielding stocks tend to be concentrated by sector and industry. Focusing solely on dividend yield can increase risk. Focus on total return, and you have a better target.

Now, you're probably thinking, "but how do I get cash? I don't want to sell principal". Few believe this, but it's true: It's ok to sell stocks to generate cash flow. Lighting won't strike you. Buying and selling individual stocks is cheap and easy. Considering the top tax rate on capital gains is less than the top rate on dividends, selling stock could be a cheaper way to get cash than dividends. It depends on your situation, of course, but it's possible.

When you let yourself sell stock to get cash, you have much more freedom. You aren't a slave to one narrow category of stocks - the whole market is yours. You can pick a strategy based on your goals and time horizon. Custom tailoring.

Your long-term goals, cash flow needs and time horizon should determine your strategy. Do you need your portfolio to generate cash to fund your living expenses? How much? Do your assets need to provide for you for the rest of your life? Your spouse's life? Life expectancies are long and getting longer. If you're approaching or are early in your retirement, you probably need your pension to last decades. Because of inflation, you'll probably need to take more cash in the future than today. To avoid running out of money, you probably need your pot to grow over time.

Dividend-yielding stocks

Use a goals-based approach like this, and it's clear picking a strategy based on income yield won't cut it. You need a certain long-term return to reach your goals. The right strategy for you is the one with the highest probability of generating that return over your entire time horizon. That probably includes some dividend payers. But you needn't be constrained by those high payers alone. You can pick stocks like these.

A bit cheaper and better run than peers, but larger, Union Pacific is one of America's oldest publicly traded rail lines, linking 23 states in the West and Midwest via the best routes. Invest in the West. This one's the best. It won't go off track at 15 times my 2015 earnings estimate with a 1.9% dividend yield.

As retailing evolves into macro-oligopolies, one dominator is CVS Caremark, in drug delivery. It will advance from both the inevitability of insurance-revenue growth and aging baby boomers' propensity for endless, self-obsessed medical spending. It sells at 14 times my 2015 earnings estimate with a 1.5% dividend yield.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.