Our three sources of stable and growing income

25 October 2019

OurThreeSourcesHighlight

For a retiree the most important factor is regular income

When we were first designing our innovative Martin Currie Australia Equity Income strategy in 2010, we went back to first principals and focussed on what made sense for a retiree from an ‘sufficient income for life’ perspective, rather than what an accumulator in the workforce needed.

We found that a key risk to a ‘sufficient income for life’ is the reliability of income. Pre-retirement, when you earn a wage from full time employment, you can generally rely on the amount you will be paid each week or month will not unexpectedly drop. But how do you ensure returns from your investments are as reliable?

We believe that income reliability can be improved by diversifying the way that income is sourced. Below I lay out three innovative ways we source reliable income for clients in our strategies on the retirement income platform.

We first launched the Equity Income strategy in May 2010. Since then, we have expanded our income platform to include Real Income (Dec 2010), Diversified Income (May 2014) and Ethical Income (Dec 2015).

1. Sustainable base distribution

We believe that for retirees, in order to create a more stable income stream a greater portion of a portfolio’s total return should be derived from dividend income than from capital growth.

By drawing down income from dividends paid, we can avoid the downward spiral caused by drawing down on capital to fund ongoing living expenses: the impairment of the future dollar income generation of assets, the risk of running out of capital, and the inability to fund a possible 30+ year retirement.

However, an important factor in maximising returns from income is how to choose stocks that will provide both a high and stable income over time. The Martin Currie Australia (MCA) investment process favours high-Quality stocks with proven Sustainable Dividend paying ability - companies that can continue to pay attractive dividend income into the future. It helps us to avoid income shocks from companies that cut dividends unexpectedly.

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Sustainable Dividend is our analyst team’s estimate of a company’s ability to maintain payments to shareholders. It is the assessment of a company’s free cash flow through different stages of the cash flow cycle.

In the Equity Income strategy, our focus on Sustainable Dividend (in addition to Quality, Valuation and Direction) means we typically avoid the resources and healthcare sectors. Resource companies like BHP tend to have high volatility in their earnings and dividends, whilst growth stocks like CSL typically have low Sustainable Dividends and trade well above our assessed Valuation1.

2. The franking free lunch

Franking can help retirees to get even more of their return from the dividend income stream and rely less on the capital growth component.

After-tax income for retirees can be maximised by explicitly attributing franking benefits for 0% tax payers by actively selecting the companies that are paying a high-franked dividend rate as well as sustainable base dividends. The MCA investment process formally values franking credits and penalises unfranked dividends in our Valuation, and therefore franking is a driver of every investment decision.

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And that income from franking is significant, and stable. Since the inception of the Equity Income strategy in May 2010, the additional tax refund available has signified almost a quarter of the annual income return2.

From a forward-looking perspective, the Equity Income strategy is offering a next twelve-month (NTM) franked income yield of 6.5%, a 25% premium over the unfranked yield. In comparison, franking for the S&P/ASX 200 accounts for only 18% of an already lower expected yield.

NTM income yield comparison3

3. Unique “fifth” distribution

A strategy we implemented to support and reinforce income stability and income growth was to include a unique fifth distribution structure in all Australian unit trusts in the Legg Mason Martin Currie Retirement Income Fund range4.

How does this work? Unit trust structures typically must distribute any realised capital gains at 30 June. If a unit trust has realised outsized capital gains during the year, paying these out can result in a deterioration of the capital base. To help preserve the capital base, all net realised capital gains accrued during the financial year are reinvested and issued as additional units in the Fund.

By adding this fifth distribution feature, we can further grow the investor’s capital base and provide more stable cash distributions.

The chart below shows the three sources of income in action, and you can see that over time, the portion of income that is derived from reinvesting realised capital gains has compounded to grow the distribution.

Rolling 12-month income from A$100 investment5

Outcome is reliable high and stable income

For the Equity Income strategy, forecast distributions and franking have typically been very stable over time, and expected income has grown ahead of inflation.

And, when compared to an equivalent investment in term deposits6, the absolute level of NTM expected income has been attractive.

NTM expected income from A$100 investment7

Reliability of income is key risk for retirees

Risk is often discussed in terms of total return volatility or a maximum peak to trough drawdown in returns. Equities are often classified as ‘riskier’ based on these measures.

But for a retiree the most important risk factor is having that regular income to fund their living expenses. We have found that the strategies which improve income from Equities can also lower both the maximum drawdown in expected income and income volatility.

As a result, the Equity Income strategy has had a much lower income drawdown than the broader S&P/ASX 200 Accumulation Index, a typical high yield index smart beta approach8 and particularly term deposits.

Maximum drawdown in NTM expected income since 31 March 20139

The certainty and stability of income for retirees can be improved by focussing on multiple income sources: investing in companies that pay Sustainable Dividends, actively seeking high levels of franking, and improving income growth by reinvestment of capital gains.



Past performance is not a guide to future returns.
1 The information provided should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any of the security transactions discussed here were, or will prove to be, profitable.
2 Source: Martin Currie Australia, FactSet; as of 30 September 2019. Data calculated for a representative Martin Currie Australia Equity Income account in A$ gross of management fee. Inception Date: 31 May 2010. Assumes zero percent tax rate and full franking benefits realised in tax return.
3Source: Martin Currie Australia, FactSet; as of 30 September 2019. Data calculated for a representative Martin Currie Australia Equity Income account. The NTM Income yield is calculated using the weighted average of broker consensus forecasts of each portfolio holding – because of this, the returns quoted are estimated figures and are therefore not guaranteed. Assumes zero percent tax rate and full franking benefits realised in tax return.
4Retirement Funds include: Legg Mason Martin Currie Equity Income Fund, Legg Mason Martin Currie Ethical Income Fund, Legg Mason Martin Currie Ethical Values with Income Fund, Legg Mason Martin Currie Real Income Fund and Legg Mason Martin Currie Diversified Income Fund.
5Source: Martin Currie Australia, FactSet; as of 30 September 2019. Data calculated for the Legg Mason Martin Currie Australia Equity Income Fund in A$ gross of management fee. Inception date: 7 June 2011. Assumes zero percent tax rate and full franking benefits realised in tax return, and quarterly distributions are taken.
6Average ‘special’ rate (all terms).
7Source: Martin Currie Australia, FactSet; as of 30 September 2019. Data calculated for a representative Martin Currie Australia Equity Income account in A$ gross of management fee. Inception Date: 31 May 2010. Assumes zero percent tax rate and full franking benefits realised in tax return, and quarterly distributions are taken.
8Based on the iShares S&P/ASX Dividend Opportunities ETF as a proxy for rules-based tilts towards high-yielding stocks.
9Source: Martin Currie Australia, FactSet; as of 30 September 2019. Data calculated for a representative Martin Currie Australia Equity Income account in A$ gross of management fee. Data start date: 31 March 2013 due to availability of yield data for the iShares S&P/ASX Dividend Opportunities ETF. Assumes zero percent tax rate and full franking benefits realised in tax return, and quarterly distributions are taken.


Important information

Past performance is not a guide to future returns.
The information contained in this presentation has been compiled with considerable care to ensure its accuracy. But no representation or warranty, express or implied, is made to its accuracy or completeness. Market and currency movements may cause the capital value of shares, and the income from them, to fall as well as rise and you may get back less than you invested.
The information provided should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any of the security transactions discussed here were or will prove to be profitable.

Martin Currie has procured any research or analysis contained in this presentation for its own use. It is provided to you only incidentally, and any opinions expressed are subject to change without notice. The opinions contained in this document are those of the named manager(s). They may not necessarily represent the views of other Martin Currie managers, strategies or funds. Please note the information within this report has been produced internally using unaudited data and has not been independently verified. Whilst every effort has been made to ensure its accuracy, no guarantee can be given.