null Bridging the Funding Gap: Equity Income’s Emerging Role in Retiree Portfolios
Manager Insights

Bridging the Funding Gap: Equity Income’s Emerging Role in Retiree Portfolios

Manager Insights Article Income Equity
November 2020
Bridging the Funding Gap: Equity Income’s Emerging Role in Retiree Portfolios

The push and pull of aging demographics and the current dearth of yields globally is creating an incredibly challenging environment for retirees. As yields approach 5,000 year lows and more people retire than ever before, the divergence of demand for income and the supply of income presents investors with a huge problem. We believe that equities can bridge this funding gap. Our proprietary framework seeks to deliver income as an outcome and generate sustainable and consistent income with low volatility. We believe these qualities are crucial to addressing the funding needs of retirees.

Historical Yields1

Sources: BofA Global Investment Strategy, Bank of England, Global Financial Data, Homer and Sylla "A History of Interest Rates" (2005).

The Retirement Crunch

Retirement can be an exciting and daunting prospect. Many retirees have diligently saved their entire working lives to enjoy their retirement comfortably. However some of their funding assumptions have likely changed since they embarked on their saving journey some 30 years ago. Notably, interest rates have collapsed globally to nearly 0%, plunging from the 20% range in 1980. While attractive from a volatility perspective, income generation from government bonds is clearly underperforming from an income-generation perspective. 

To further illustrate the challenges that retirees face, we will consider a hypothetical couple that built a $1 million nest egg over the past 30 years. This couple has an income generation assumption that they could apply to this nest egg to finance their retirement. Ten years ago corporate yields were in the 6% range, though today they sit at 3.24%. The decline of interest rates have cut their monthly income generation from a robust $5,510 down to a bit more challenging $1,480 This material erosion of income is then compounded by the numerous unavoidable costs typically faced by retirees, particularly healthcare. 


Income Derived from $1 million Investment Grade Bond Portfolio

Source: Bloomberg. As of October 31, 2020.

The New Inflation

Further exacerbating a retiree’s search for income is an inflation trend that uniquely exposes retirees: healthcare inflation. As noted previously, the ability to fund one’s retirement is declining materially while the need for that income is growing. Healthcare costs are contradicting our current low inflation environment as the growth of healthcare costs exceed those of most other expenditures. The average retiree spends around $5,000 a year on healthcare (a couple spends $10,000), which is manageable when a retirement fund is generating $66,120 annually but less so when it’s generating only $17,760 annually. This funding gap will have a real impact on retirees’ spending ability. However we believe a large portion of additional healthcare costs can be offset with a careful allocation to high quality, consistent and sustainable sources of equity income. 


Healthcare Inflation versus Normal Inflation

Source: Federal Reserve Bank of St. Louis. As of September 1, 2020

Addressing the Problem

We have developed a platform of income generating portfolios designed to address these emerging funding needs and have a decades-long history of delivering robust yielding strategies with low income volatility. Our investment process utilizes our proprietary framework centered on income as an outcome combined with careful analysis of company cash flow sustainability and a focus on a company’s willingness to deliver yield. Revisiting our hypothetical retirement couple, we can see that they could successfully fill some or all of their funding gap by allocating to stable equity income. Through the use of a thoughtfully constructed, outcome oriented equity income strategy that targets a consistent, sustainable 6% dividend yield, this couple would have kept pace with persistent healthcare inflation costs.

Retirees have worked diligently for decades, saved responsibly and built sizable nest eggs, which they thought would ensure a comfortable retirement. Unfortunately market forces have injected some uncertainty into this retirement scenario. We believe our proprietary income as an outcome platform offers clients a compelling approach to closing this funding gap. 

1.Notes: intervals on the x-axis change through time up to 1700. From 1700 onwards are annual intervals. Prior to C18th rates reflect the country with the lowest rate reported for each type of credit: 3000BC to 6th century BC - Babylonian empire; 6th century BC to 2nd century BC - Greece; 2nd century BC to 5th century AD - Roman Empire; 6th century BC to 10th century AD - Byzantium (legal limit); 12th century AD to 13th century AD - Netherlands ;13th century AD to 16th century AD - Italian states. From the C18th the interest rates are of an annual frequency and reflect those of the most dominant money market: 1694 to 1918 this is assumed to be the UK; from 1919-2015 this is assumed to be the US. Rates used are as follows: Short rates: 1694-1717- Bank of England Discount rate;1718-1823 rate on 6 month East India bonds; 1824-1919 rate on 3 month prime or first class bills; 1919-1996 rate on 3month US Bankers' Acceptances ; 1997-2014 rate on 3month AA US commercial paper to non-financials. Long rates: 1729-1919 - rate on long-term government UK annuities and consols; 1919-1953, yield on long-term US government bond yields; 1954-2015 yield on 10 year US treasuries.

Reprinted by permission. Copyright © 2020 Bank of America Corporation (“BAC”). The use of the above in no way implies that BAC or any of its affiliates endorses the views or interpretation or the use of such information or acts as any endorsement of the use of such information. The information is provided "as is" and none of BAC or any of its affiliates warrants the accuracy or completeness of the information.


PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.


Mellon Investments Corporation (“Mellon”) is a registered investment advisor and subsidiary of The Bank of New York Mellon Corporation (“BNY Mellon”). Any statements of opinion constitute only current opinions of Mellon, which are subject to change and which Mellon does not undertake to update. This publication or any portion thereof may not be copied or distributed without prior written approval from the firm. Statements are correct as of the date of the material only. This document may not be used for the purpose of an offer or solicitation in any jurisdiction or in any circumstances in which such offer or solicitation is unlawful or not authorized. The information in this publication is for general information only and is not intended to provide specific investment advice or recommendations for any purchase or sale of any specific security. Some information contained herein has been obtained from third party sources that are believed to be reliable, but the information has not been independently verified by Mellon. Mellon makes no representations as to the accuracy or the completeness of such information. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment and past performance is no indication of future performance. The indices referred to herein are used for comparative and informational purposes only and have been selected because they are generally considered to be representative of certain markets. Comparisons to indices as benchmarks have limitations because indices have volatility and other material characteristics that may differ from the portfolio, investment or hedge to which they are compared. The providers of the indices referred to herein are not affiliated with Mellon, do not endorse, sponsor, sell or promote the investment strategies or products mentioned herein and they make no representation regarding the advisability of investing in the products and strategies described herein. Please see mellon.com for important index licensing information. CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute.