In this article I take inspiration from NFB’s last “View from the Chair” editorial in which Mike Estment mentioned that as he approaches retirement, he has begun to “leave the tree but trim the fruit”.

This is similar to an analogy that I have been using for some time with my clients in which I explain how fruit from an orchard can be compared to the yield from your investments. Both require time and patience but once your “tree” is fully grown, the amount of fruit you can harvest depends on how well you care for your tree.
   

How are investment returns made up and how is that important to the shorter- or longer-term investor?   

      
Investment returns are often made up of two components, namely an income and a capital growth component. Some asset classes such as cash or bank deposits consist only of interest or yield, while some equities don’t pay dividends and are all about growth in the asset price.

For the younger set or those still working, the income component is not important for day-to-day expenses, so these yields (or fruits) are re-invested. These investors want their tree to grow and want more trees in their portfolio orchard so that one day there is sufficient fruit/income that can be borne by the portfolio. This ensures the portfolio can continue to grow whilst the yield covers the income requirement.  
  

So, are our markets (and your investments) currently bearing fruit?

 
"Interest rates and yields have been low for a while but recently, with inflation pushing higher after years of stimulus yields from certain assets classes are starting to look attractive".

Cash rates are now close to 6% for money market, with rates as high as 8% over 2 years and more than 9% for 5 years.

Longer-term Bond yields are looking particularly attractive with earnings north of 11%. Bonds are not without risk but the coupon on offer should more than compensate. Rates have moved out to levels last seen during the Covid sell-off.

Income Funds, which focus on shorter dated bonds, fixed interest, and bank instruments as well as property, are yielding around 8%.

Property has long been a provider of a solid income stream along with some capital growth prospects. Covid exposed the risks in property, but this battered and bruised asset class has recovered strongly and is starting to present some good opportunities. Yields or rental distributions are back on track and providing double digit returns. Capital valuations have not yet returned to pre-Covid levels and there is still room for this to re-rate, giving investors an opportunity to lock-in on a good income stream with some capital upside.

As equity markets have been under pressure, equity prices have fallen. This does not only provide capital growth opportunities with some reasonable entry points, it also makes the dividend yields look more attractive. Simply put, dividends are the share of profits not re-invested into the company but instead, is paid out to shareholders. Many companies have restructured through Covid and have been able to release more capital to investors by the way of dividends. A good example is the mining companies that have benefited from the recent commodity boom. Rather than dig more holes in the earth, they have paid out these profits in the form of dividends, some of which have been as high as 8%.

Our own equity partners, NVest Securities, manage specific mandated equity portfolios that have an income focus. An example of this would be their Dividend Growth, Income Growth and Living Annuity portfolios where yields are between 5% and 7%.
   

The investment vehicle used can make a big difference

 
The problem with the income component is that most of it is taxable. It is therefore important to understand the after-tax return of these yields. Depending on the investments vehicle in which these are housed, this can make a material difference. Remember, there is no tax applied to your Retirement Annuity, Preservation Fund, Living Annuity and Tax-Free Savings Account.

There are certain products that still offer guaranteed rates that are tax efficient. These are often in the form of 5-year guaranteed endowments where the return offered is an after-tax rate. At the time of writing, these rates were in the region of 7.5% p.a. which equates to a 14% pre-tax return assuming the top marginal tax rate.

The next time you get your statement or sit with your Advisor take note of the distributions on your statement. Coupled with the market or price movement, this will give you your overall return. For those drawing an income, it is good to have your distributions cover your income, leaving the market growth to hedge against inflation.

Understanding how the distributions in your portfolio work and how these are used or re-invested are an important component of your retirement planning.

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This article features in the 2022 issue 3 edition of the Proficio, NFB's bi-monthly financial update newsletter. Download the complete newsletter here.