The goal for most retirement portfolios is to have a stable stream of income. The challenge of generating it now may require a change in strategies.
“A stable stream of income is hard to find these days with all the market volatility,” says Michael Dehal, senior vice president and portfolio manager, private client group, at Raymond James Ltd. in Montreal.
The volatility in March, 2020 was an “especially scary time,” he says, because it quickly spread across all asset classes.
“Not just in equities but in fixed income as well, you had spreads widen to levels unseen since 2009. So, the need for steady income is even more important now,” Mr. Dehal says.
To compensate for lower bond income, Mr. Dehal will soon start incorporating roughly 10 per cent of his clients’ retirement portfolios into alternative investments.
“I do hold alternative investments for clients, where every month they pay a distribution regardless of whether the markets are up or down,” he says. “More alternatives like private debt, which are not correlated to public markets, can still give you that monthly income.”
Mr. Dehal adds that for retirement income, in particular, in which low volatility is desired, a 10-per-cent exposure to alternative investments can be prudent. “That can generate income as well, and might also be a good way to diversify,” he says.
Conventional wisdom no longer applies when building a retirement portfolio, says Michael Kovacs, chief executive officer of Harvest Portfolios Group. The traditional 60-40 split between equities and bonds has, by necessity, shifted in response to recent market turmoil.
“What has worked for the past couple of decades may not work as well in the future,” he says. “We had this huge bull market in bonds for decades, but you might see bonds struggle a lot more going forward.”
Mr. Kovacs says he anticipates a prolonged low-interest rate environment.
“I am suggesting that equity be a much bigger component than what it has been traditionally for retirement,” he says. “Even in an inflationary environment, with interest rates eventually picking back up and the economy getting better, that all bodes well for stocks.”
Mr. Kovacs says there are still plenty of ways to find stable income and low volatility, even with portfolios tilting more and more heavily toward equities.
“The large-cap names produce growth over time,” he says. “We like the larger caps in particular because they’re well-established, have deep market capitalizations and pay consistent dividends.”
Both Mr. Kovacs and Mr. Dehal recommend covered-call strategies as a good way to maximize incomes in a low-interest-rate environment. Mr. Dehal is a fan of the Harvest Healthcare Leaders Income ETF, which trades on the Toronto Stock Exchange under the HHL ticker.
Harvest Healthcare Leaders Income ETF is an equally weighted portfolio of 20 large-cap health care companies, selected specifically for their potential to provide stable monthly income. The ETF uses an active covered-call strategy to generate an enhanced monthly distribution yield. That increases short-term income by limiting longer-term gains.
Mr. Dehal notes that some volatility comes with covered-call ETFs, “but that’s the trade off you do have to make to generate monthly income.”
It can be tricky to get the balance right for a solid retirement income. Tom Davidoff, a professor at the University of British Columbia’s Sauder School of Business, says retirees with 40 per cent of their portfolios still in bonds are “obviously not going to get great bond returns for the foreseeable future.”
Despite that, “you have to be very careful about going to, say, 80-20 as a way to juice your returns,” he says.
“You can either eat well or sleep well,” Mr. Davidoff says. “With equities, I think most people should be in an index fund or an exchange-traded fund. They shouldn’t try and outsmart the market.”
So, what is the right balance to maximize income while mitigating risk?
“Over time it’s become evident that the best mix for option writing is somewhere between 25 per cent and 33 per cent, depending on where we are in the market cycle,” Mr. Kovacs says. “It seems to be that if you’re writing [options] in that range, you can still capture a good amount of the upside if the market is strong, but also generate some cash flow into the portfolio.”
One benefit of an options-writing strategy, as a means of generating income, is the potential for tax benefits.
“If you are taking it outside an RRSP, it is more efficient to take option premiums because they are considered capital gains,” Mr. Kovacs says. “Capital gains are much more tax-advantaged to generate income as opposed to just pure interest income.”
Regardless of how investors adapt, Mr. Dehal says the days of the 60-40 split are done.
“Given what we experienced in 2020, money managers and portfolio managers like myself have got to rethink that mix,” he says. “We are going to be seeing a lot more volatility.”