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Retirement Planning > Spending in Retirement > Income Planning

Retirement Income Investing in a Low-Yield World

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What You Need to Know

  • Investors are not always rational, contrary to common assumptions in economic theory.
  • Retirees have a clear preference to not deplete wealth, largely due to an uncertain lifespan.
  • Investing in equities for the long term may become attractive to income-focused investors as the relative dividend yield increases.

Investors are not always rational, contrary to common assumptions in economic theory. While this statement may seem obvious to financial advisors, this disconnect has led to a dearth of research exploring efficient strategies for “behavioral” investors (i.e., those with irrational preferences).

One example of an “irrational” preference would be for income, a goal that is especially common among retirees. In theory, a retiree (or investor) should be indifferent between liquidating capital and yield; however, retirees have a clear preference to not deplete wealth.

For example, a Society of Actuaries survey noted that only 17% of pre-retirees planned to spend down their wealth in retirement, while 32% planned to withdraw only earnings and leave principal intact.

When it comes to generating income, an investor theoretically should be indifferent between liquidating capital and yield, because they have similar effects on the value of a portfolio.

In reality, income-focused investors typically have a strong preference against selling down principal despite the potential inefficiency of the approach and implications on the available opportunity set of investments.

These investors also typically have a strong preference against purchasing an annuity, despite the fact annuitization is widely considered the most efficient approach for generating retirement income (and hedging longevity risk).

A potential behavioral justification for the desire to not spend down capital is an uncertain lifespan. There have been notable gains in longevity in the past few decades, especially among wealthier Americans, and leaving principal untouched is a potential approach to mentally manage an uncertain lifespan.

Additionally, leaving the principal untouched creates the possibility of a bequest.

Difficult Investment Choices

These are difficult times for those focused on income-producing investments, with yields on 10-year government bonds hovering around 1.5%.

While equities are generally considered prudent only for investors with a high risk tolerance and longer time horizon, given the notable price return volatility, to the extent an investor is able (and willing) to hold equities for the long term (e.g., five-plus years), they may become attractive to income-focused investors as the relative dividend yield increases.

More on this topic

In some new research I wrote that was just published in the Journal of Wealth Management, I specifically explore optimal equity allocations for income-focused investors leveraging data primarily from the Jordà-Schularick-Taylor Macrohistory database, which includes returns from 16 countries from 1870 to 2019.

Bond yields have exceeded dividend yields by approximately 1.5%, on average, historically. When bond yields have exceeded dividend yields, income-focused investors should have allocated relatively little, if anything, to equities.

While equity allocations increase slightly when considering taxes, because dividends are more tax-advantaged than bonds, when bond yields are high that has been the best place to get income.

Today, though, in an environment when dividend yields on equities are roughly equal (e.g., yields on the S&P 500 and 10-year government bonds are both about 1.5%) the optimal equity allocation historically increases significantly, and has been closer to 50% for a moderately risk-averse income-focused investor, ignoring taxes, and slightly higher (e.g., 60%) if taxes are considered.

This isn’t necessarily surprising, but it does suggest income-focused investors historically would have benefited from shifting to equities based on relative yields, something I’m guessing many investors are already doing.

While lower-than-average equity returns would have reduced optimal equity allocations for income-focused investors, even if equity returns had been 3% lower (effectively eliminating the majority of the realized equity risk premium), optimal equity allocations would have been closer to 30%.

In other words, the yield effect is relatively robust even if future equity returns are lower (reflecting the relatively high valuations).

Because not all investors are utility-maximizing robots focused on total returns, advisors need guidance on how to build efficient portfolios for these “behavioral” investors.

My analysis, relying on historical returns, suggests that equities have been an attractive way to generate income during historical periods when dividend yields have exceeded bond yields.

Allocating to equities significantly increases the price return risk of a portfolio, though. Therefore, investors interested in using equities to generate income need to be able and willing to stay invested in equities for the long term.


David Blanchett is managing director and head of retirement research at PGIM DC Solutions. PGIM is the $1.5 trillion global investment management business of Prudential Financial. He can be reached at [email protected].