Income streams can flow from different sources

There is a great deal of theory available about how diversification impacts total return or capital volatility. The concept of efficient frontiers, for example, focuses solely on total return.

Generally there is much less discussion on the income side of the equation. That is, which combination of assets produces desirable outcomes in terms of smooth, growing and tax-efficient income streams. Yet this is an important subject, particularly for those who are living on their investments.

In assessing the attractiveness of the various income streams, I’ll consider initial yield, variability of income, growth of income and tax efficiency.

As the income from some asset classes will grow, the asset that delivers the highest initial distributions may not produce the most income in the long-term.

At the time of writing, listed property trusts are yielding 7.4 per cent, 10-year bonds 5.6 per cent, 90-day bills around five per cent and dividends 3.9 per cent. However, even if these rates were to remain constant the relationship between the levels of distribution would change over time.

The income from property and shares should be produced from a growing capital base.

Although there are many other factors involved, it is a reasonable hypothesis that, over the long term, rents will continue to increase while we have inflation.

Thus property offers the prospect of delivering income that goes some way to matching cost of living increases.

Notwithstanding fluctuations in the business cycle, corporate profits, and therefore dividends, can be expected to grow more rapidly than inflation. At January 1, 1980, the All Ordinaries Index was 500. Currently it is a little above 3,000. Dividends in the early 1980s averaged around five per cent whereas today they are a little under four per cent.

A four per cent yield on 3,000 is almost five times more than a five per cent yield on 500, so income growth has been very strong. This comfortably exceeds the tripling of the cost of living over the period.

Although the stock market initially produces the lowest level of income, over the long-term it is likely to prove the strongest income stream.

Interest rates cannot increase in perpetuity, so one of the failings of fixed interest as an income source is its lack of growth.

The tax treatment of these various income sources varies. Dividends benefit from franking and rent from tax-free or deferred components.

Table 1 shows that, initially, property produces by far the highest net return, in any tax bracket.

Although the rate of dividend is less than bond and cash rates, after tax it matches bonds and beats cash for both top and bottom rate taxpayers.

This is an interesting and rarely commented on phenomenon. There is a cash flow opportunity cost from investing in cash rather than dividends! (Of course, in this article, I am focusing solely on income and ignoring the potential for gains and losses, which is clearly material in determining asset allocation.)

I have included only domestic assets in this table. If international shares were included, they would look uncompetitive with world stock markets offering dividends of around two per cent, which are unfranked.

One of the vital aspects in analysing income sources is that those assets that produce a high volatility of capital do not necessarily produce highly variable income. Share prices fluctuate much more than dividends both because of the short-term tendency of markets to overprice or underprice stocks, and also because company boards often smooth dividend payments.

Thus an investor in an equity portfolio can receive a reasonably stable income stream in a period of significant short-term capital volatility.

At the other end of the spectrum is cash. It provides absolute stability of capital but generates a highly variable income stream, ratchetting up or down every time interest rates are adjusted. In fact, Graph 1 shows that, since 1980, there has been an enormous variation in cash rates. If this was the only source of income, investors would have been able to spend four times as much in some years as others. Bond rates have also fluctuated materially, but less so than cash.

Listed property trusts offer relative stability of income due to the underlying nature of leases. Rents are generally reviewed annually and usually only are adjusted by a few percentage points.

The decline in inflation over the last two decades has had a very strong impact on interest rates, which have declined markedly. In terms of total return, bond investors have had the compensation of capital gains from falling interest rates whereas cash investors simply earned less income.

Therefore, it could be said that property is a very attractive income asset, offering the highest initial yield, both gross and net, with relatively low volatility of distributions, and the capacity to grow income over time.

Bonds, and particularly cash, carry quite high volatility of distributions. They produce a higher initial yield than dividends, but not in after-tax terms, and have no long-term income growth potential. Ironically, income-oriented investors should not focus excessively on fixed interest investments.

Dividends will vary more than rent but less than interest rates. They will initially provide only a low level of cash yield, but offer tax advantages and a stronger long-term growth.

‘Growth’ assets, therefore, should play strong roles in portfolios if income was the only objective.

Fund managers are generally judged on total return. Planners face a more complicated challenge in meeting the needs of clients who live on their investments.

We tend to be assessed on two criteria — whether the client’s income is adequate for their needs and whether the capital value of their portfolio is rising or falling. Both criteria need to be considered in portfolio construction.

Many retiree portfolios rely on allocated pensions, which offer a simplification of this issue by breaking the nexus between the income earned on the portfolio and the cash paid to investors. This artificially smooths income.

However, they are not a magic pudding and, if the amounts distributed significantly exceed the income earned on the underlying portfolio, it is clearly eating into capital. This is not a problem while assets rise but is dangerous when they decline.

There is one more issue of interest in regards to income from equities. It is sometimes argued that more than half the returns from the share market comes from dividends.

This is obviously true while markets are flat or declining, but is mathematically incorrect over recent decades. The basis for the claim is that accumulation indices have grown at more than twice the rate of price indices — therefore it appears that dividends must be more than half the return.

However, consider the example of a $10,000 investment that produces three per cent growth and two per cent income over 25 years. Obviously the two per cent dividend is less than half the five per cent total return.

Yet the $10,000 will only grow to produce $10,938 profit at three per cent per annum and will produce $23,864 profit at five per cent — more than twice the profit. This is a phenomenon of compounding at different rates. It does not prove that two per cent is greater than three per cent.

From January 1, 1980, to January 1, 2002, the All Ordinaries price index increased at 7.3 per cent per annum and the Accumulation Index returned 11.6 per cent per annum.