October 20, 2021 | macro-economic research report

Research Report: Search For Income

BY: Richard Croft
A central theme in portfolio management is risk-adjusted return. Weighing potential upside performance against downside variability is the essential element in setting an appropriate asset mix.



A central theme in portfolio management is risk-adjusted return. Weighing potential upside performance against downside variability is the essential element in setting an appropriate asset mix.

Most investors understand the performance side of the equation. Simple arithmetic: set an objective, determine the time horizon, and calculate a required rate of return.

Risk is more subjective. We can measure risk by calculating a portfolios variability over a specific period. But knowing a portfolio could experience x% downside variability sheds no light on how investors are likely to react.

Notionally, we can use questionnaires to determine an investor’s risk tolerance. The reality: measuring risk tolerance ex-ante is like trying to guess Connor McDavid’s next move based on his latest trajectory. It might be better than a blind guess, but not by much.

The risk question is especially relevant for income portfolios. With their own nomenclature, which defines risk as the “age of ruin,” or how long the portfolio can fund the investor’s needs and wants before it runs out of money.

Income mandates are conservative as they appeal to retired seniors who, by definition, have a low tolerance for risk. Conservative income portfolios are typically over-weighted in fixed income securities (i.e., bonds and preferred shares) with a limited allocation to equities.

But does an overweighted bond allocation reduce risk in an ultra-low interest rate environment? Bond prices move inversely to interest rates. Rising rates lower bond prices, declining rates, raise them! If interest rates remain where they are, bond prices will trade in a narrow range which will provide ballast within the portfolio. However, any increase in rates will cause a precipitous decline in bond prices effectively negating the perceived risk reduction benefits associated with fixed income assets.

Fixed income risk also varies on a sliding scale that corresponds to the term to maturity.

With rates at or near zero and inflation rising, it is hard to imagine a scenario where rates will decline significantly. Some analysts have posited negative interest rates for North America but, we believe it is more likely rates will rise or, at best, remain where they are for the foreseeable future. In that light, bonds may be the highest risk asset class.

So, our base case for interest rates negates much of the risk reduction benefit one might get from holding bonds in an income mandate. Developing sustainable income portfolios in the current environment means altering our perception of risk; looking past price variability and focusing instead on income variability.

Easier said than done! Downside variability can be catastrophic, often leading to bad decisions based on emotions… notably fear and greed. However, an income portfolio with low price variability that is unable to generate the required income will require principal withdrawals, which all but guarantees an age-of-ruin timeline.

We can manage bad behavior caused by short term price swings by recognizing that variability varies by time (i.e., the length of time you hold an investment). Looking at long-term performance data makes short-term aberrations seem less important. The key is being comforted by the knowledge that solid, blue-chip value stocks will recover in time.


We have found, generally, that the income needs of most retirees exceeds the cashflow that can be generated by the investment allocations within a traditional income portfolio (i.e., 70% bonds, 30% equity). To offset the shortfall, the portfolio manager must sell assets, which necessitates a drawdown of principal. For many retirees, these drawdowns outweigh the advantages of reduced variability.

Think about it this way. Suppose you have $100,000 in laddered GICs yielding 2% per annum. That portfolio might generate $2,000 per year in income with no tax benefit. If at age 65, your required annual income is $6,000, you will be drawing down principal at a rate of $4,000 per year. The portfolio will have zero variability, and guarantees that you will run out of money before age 83.

Rather than guaranteeing to erode the retirees’ principal, a portfolio generating more income with heightened price variability may be the better approach. Using the same analogy, suppose a hypothetical $100,000 portfolio that includes dividend paying stocks and option writing strategies might produce $5,000 per year in tax-advantaged cash flow.

Managing the shortfall requires an annual drawdown of $1,000. This drawdown is less intrusive, but it can be painful if it occurs at a time when the portfolio is experiencing a sharp sell-off.

There lies the trade-off! Is a minimum volatility portfolio appropriate if you are forced to draw down excess principal? Or does a higher yielding, potentially volatile mandate make more sense in an ultra-low interest rate environment?

To shed light on potential variability linked to this example of an Enhanced Income mandate, we incorporate a “cone of uncertainty” bracketing best- and worst-case scenarios. In this example, because drawdowns are less intrusive, the Enhanced Income portfolio should be sustainable until at least age 89 and could last a lifetime.


How do taxes fit into this discussion? Interest income is taxed as ordinary income, which means you pay the marginal tax rate on total cash flow. Dividends from common and preferred shares and capital gains from option writing strategies are more tax efficient, so may require less of a drawdown to end up with the same after-tax cash flow.

Going back to our previous example, $2,000 of interest income from the hypothetical GIC portfolio will, depending on your marginal tax rate, deliver approximately $1,350 of after-tax income. The same sized Enhanced Income portfolio delivering $5,000 in dividend and capital gain income will leave you with about $4,150 in after tax income. So, you would require three times the portfolio in GICs to generate a similar after-tax income from your portfolio.

And what about inflation? Significant government deficits have, historically, been inflationary. Adjustments to your monthly income for cost-of-living increases can have an outsized impact on principal drawdowns.



In our experience most investors cannot survive on the modest income generated by investing their portfolio in a laddered GIC portfolio or buying an annuity. These ‘guaranteed’ choices simply do not generate enough cashflow and cannot effectively offset inflation expectations. In the real world, the more realistic choices are either a more traditional income allocation (70% bonds, 30% equity) or a more tax-efficient Enhanced Income mandate that focuses on value stocks with solid dividends, preferred shares and income trusts, bolstered by option writing strategies.

Choosing a traditional versus an Enhanced Income portfolio rests with investors’ ability to tolerate increased portfolio variability. An Enhanced Income portfolio theoretically carries greater risk both in terms of price variability and the fact that, for convertible or common equities, corporations can choose to withhold dividends to shore up balance sheets.

We can deal with the second element by selecting companies where there is a high degree of probability that the dividends will be maintained. Ideally, we want companies that have increased dividends over time, thus providing the best of both worlds. Investors enjoy the tax advantages that come with dividends and benefit potential price increases and increased cash flow, which would offset inflation increases.

The variability question hinges on the investors’ tolerance for the increased market risk of common and preferred shares, which may be more theoretical than factual. For one thing, the reduced variability in the traditional income model assumes that bonds are a low-risk alternative, which may not be the case. Still, an equity-based portfolio that pays dividends supplemented by a well-thought-out option writing program will, by definition, be more volatile.

Unfortunately for portfolio managers, we rarely know how much variability a client can absorb until it is too late. Our job at that point is to help manage emotions so the investor can weigh the benefits versus the risks and, hopefully, stay the course until better times emerge.

To get to that position we examine two portfolios: one a traditional income portfolio with a standard 70% weighting in bonds and 30% weighted to a broad-based equity ETF (see table 1) and a second Enhanced Income mandate with blue chip dividend paying stocks and an option writing income enhancement.

The Enhanced Income mandate holds a 40% weight in option writing strategies plus a basket of dividend paying common stocks, preferred shares and income trusts (see Table 2).

The question as to which approach is superior depends almost entirely on what level of income is required, assessing after-tax needs and weighing that against riding the emotional roller-coaster associated with short term variability. Ideally, not having to draw down principal during a market decline will go a long way towards ensuring the portfolio will meet expectations through an entire life cycle.

If the investor can enjoy retirement based on the income being generated by the portfolio, then the only question is whether the cash flow is consistent and sustainable. Here, the stability of the Enhanced Income portfolio cashflow is also pertinent. Historically, the dividends and capital gain distributions in our Enhanced Income mandate have exhibited greater stability than the interest and dividends generated within a Traditional portfolio.

Coming full circle, an Enhanced Income portfolio offers income stability, elevated cash flow and superior after-tax benefits, and thus a lower probability of ‘outliving your investments’ for a given level of desired income. The downside is heightened portfolio variability during market fluctuations, although that last point is debatable given the risk that increasing interest rates pose to fixed income investments.


An Enhanced Income investment mandate can be a realistic and viable option for many investors’ – especially those who have pre-defined and consistent income objectives.

Such investors could make use of an Enhanced Income mandate much as they would a pension plan for regular income. If there is the discipline not to make one-off requests for funds during market declines, values have a chance to recover and maintain the longer-term nature of the payouts required.

Investor behavior is also critical. Those who can focus on the stability of the cash flow while discounting the variability of monthly and yearly return data, will be in a better position to reap the many benefits of an Enhanced Income approach. To that point, we encourage investors in an Enhanced Income mandate to immediately begin drawing monthly income. Ideally, the consistency of the cash flow will in time (usually six to eighteen months) alleviate concerns about portfolio variability.

That latter point is particularly relevant in the current environment. The first quarter of 2020 experienced a “black swan” decline triggered by pandemic related fears. While the decline was significant, it had no impact on our Enhanced Income portfolios’ cash flows and market values have since recovered all and more of their initial drawdowns.

Proving once again that short-term market variability can be less important to a successful investment strategy than a steady hand and an eye always on the longer-term goals.

Richard croft signature

Richard Croft, Chairman & CIO

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