Tax-implications of yield vs. total return approaches to drawing income

Two plants of differing sizes, symbolizing differences from yield vs. total return approach

On September 30, 1981, income-seeking investors had it easy. The Bloomberg Barclays Aggregate Bond Index offered a yield of 16.5%. The Russell 1000® Index complemented that with a yield of 5.5% (which would climb nine months later to a peak of 6.2%). At the time, a balanced investor could have earned a 10% yield from a hypothetical 60% equity, 40% bond portfolio simply by rolling out of bed in the morning.

Fast forward 36 years, and the picture for today’s income-seeking investors is very different. As of September 30, 2017, the Bloomberg Barclays Aggregate Bond Index offered a 2.6% yield and the Russell 1000 Index’s yield stood at 2.1%.

Yields over time
Source: FactSet as of September 30, 2017. Index returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Indexes are unmanaged and cannot be invested in directly.

This has driven many investors to stretch for yield in historically riskier asset classes, like MLPs, emerging market debt and global high yield, which are yielding 7.4%, 4.5% and 5.5% as of September 2017, respectively, according to the Alerian MLP Index, Bloomberg Barclays Emerging Markets Debt Index, and the Bloomberg Barclays Global High Yield Index. Wondering how much riskier these asset classes have been in the past? The chart below illustrates it well. These higher yields have been counterbalanced by some of the worst 12-month returns dating back to January 1994: -39.7%, -29.9% and -37.1%, respectively, for MLPs, emerging market debt and global high yield.

Chart showing risk of reaching for yield

Cash: Citigroup 1-3 Month T-Bill Index; U.S. Treasuries: Bloomberg Barclays U.S. Treasury Index; U.S. Aggregate Bond Index; Credit: Bloomberg Barclays U.S. Credit Index; Long Treasuries: Bloomberg Barclays Long U.S. Treasuries Index; Global Infrastructure: S&P Global Infrastructure Index; Bonds: Bloomberg Barclays U.S. Aggregate Global REITs: FTSE EPRA/NAREIT Index; Emerging Market Debt: Bloomberg Barclays Emerging Markets Debt Index; U.S High Yield: Bloomberg Barclays U.S. High Yield Index; Global High Yield: Bloomberg Barclays Global High Yield Index; MLPs: Alerian MLP Index. Index returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

However, as my colleague, Sam Pittman, Head of Retail Solutions, has pointed out: yield isn’t the only way to generate income from a portfolio—and in many cases, it may not be the most efficient, especially when taxable accounts are involved.

Looking beyond yield for income

Depending on the investor’s circumstances and preferences, consider generating income by taking systematic withdrawals from a total return portfolio. For example, investors who:

  • prefer greater control over their cashflow pattern
  • don’t mind spending portfolio principal
  • are attempting to generate a cashflow stream from a taxable account

may find a total return portfolio helps them reach their goals in a more tax efficient manner while also reflecting their circumstances and preferences.

Let’s look at an example

Assume a $1 million nest egg from which an investor wants to withdraw $40,000 per year—a 4% withdrawal rate. Let’s consider two portfolio options for achieving this goal:

  1. Portfolio option #1: A Yield-oriented Portfolio targeting a 4% yield
    To achieve the yield target, this hypothetical portfolio would be allocated 50% to U.S. stocks and 50% to bonds. The portfolio would derive a 2% yield from dividends and 6% from bonds (mostly U.S. and global high yield bonds).
  2. Portfolio option #2: A Total Return-oriented Portfolio from which the investor will take systematic withdrawals equivalent to the $40,000 income requirement
    Let’s assume that this portfolio is allocated 60% to stocks and 40% to bonds to help it continue to grow over the long term despite the withdrawals. The stock portion of the portfolio would generate approximately 1.5% in dividend yield (assume a diversified portfolio of U.S. and non-U.S. stocks, large cap and small cap exposure); the bond portion approximately 2% (assume an aggregate bond-type portfolio). The total yield of the portfolio would be approximately 1.7%. The investor would make up the remainder of the desired income by systematically selling shares from the portfolio.

Yield portfolio vs. total return portfolio
For illustrative purposes only.

What does the cashflow stream look like for these two portfolio options—especially once taxes are considered?

In both approaches, the pre-tax cashflow is the desired $40,000. However, the after-tax cashflow looks very different for both portfolios:

  • The Yield Portfolio leaves the investor with $24,600 after taxes;
  • The Total Return Portfolio leaves the investor with $33,129 after taxes.

Cashflow stream
This is a hypothetical illustration and not meant to represent an actual investment strategy.

That 35% difference in the amount of after-tax spending is due to the higher tax rate applied to interest and dividends—from which 100% of the Yield Portfolio’s cashflow is generated—than to capital gains—particularly long-term capital gains. The Total Return Portfolio generated $17,000 of the desired $40,000 cashflow from dividends and interest and the remaining $23,000 through systematic selling of shares, thereby reducing the tax liability of the portfolio.

Of course, this doesn’t mean that a total return approach is best for all investors. In fact, a yield-oriented approach is typically a better fit for investors who have a preference to not invade principal, do not mind some variability in their cashflow, and are drawing income only from non-taxable assets. In contrast, for clients who are considering drawing income from taxable assets, want to control their cashflow pattern and don’t mind spending principal, the potential tax advantages of a total return approach may be better suited.

The bottom line

Income-seeking investors, and the advisors helping them reach their goals, face slim pickings today. Help your clients reach their income goals by ensuring that they are not reaching for more yield than the accompanying volatility they may need to stomach with these investments—and help them choose an approach to generating income that has the greatest potential for maximizing their after-tax income.

Disclosures:
These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page. The information, analysis, and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity.

This material is not an offer, solicitation or recommendation to purchase any security.

Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment.

Nothing contained in this material is intended to constitute legal, tax, securities or investment advice, nor an opinion regarding the appropriateness of any investment. The general information contained in this publication should not be acted upon without obtaining specific legal, tax and investment advice from a licensed professional.

Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns.

The information, analysis and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual entity.

Russell Investments’ ownership is composed of a majority stake held by funds managed by TA Associates with minority stakes held by funds managed by Reverence Capital Partners and Russell Investments’ management.

Frank Russell Company is the owner of the Russell trademarks contained in this material and all trademark rights related to the Russell trademarks, which the members of the Russell Investments group of companies are permitted to use under license from Frank Russell Company. The members of the Russell Investments group of companies are not affiliated in any manner with Frank Russell Company or any entity operating under the “FTSE RUSSELL” brand.

The Russell logo is a trademark and service mark of Russell Investments.

Copyright © Russell Investments Group, LLC 2017. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an “as is” basis without warranty.

Russell Investments Financial Services, LLC, member FINRA (www.finra.org), part of Russell Investments.

RIFIS: 19504

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