David Stevenson analyses Chancery Lane

This week David Stevenson wrote an article about us in Citywire. Here’s what he said:

RETIREMENT SAVINGS 24 JAN, 2023

David Stevenson: Why don’t more people realise trusts are great pension income providers?

Investing retired clients in investment trusts is an excellent idea. If you care more about steady income than steady capital growth, they fit the bill.

What many older investors care about is not the volatility of their capital but the volatility of their income. This helps explain why so many older investors focus on an equity income approach which focuses on dividend payouts, either from a company or a fund.

It also helps explain why so many fixate on numbers, notably that yield, which needs to be in the middle of a 3%-5% range. Or, if you are an American, precisely 4%. It was Bill Bengen, a financial adviser, who created the 4% rule in the mid-1990s. Bengen reckoned that even during volatile markets there were no historical examples where a 4% annual withdrawal exhausted a retirement portfolio in fewer than 33 years.

Traditionally older income investors might have plumped for bonds to provide these returns, but in the era of easy money that end yield from a diversified portfolio of bonds was difficult to achieve (if not impossible). Thus, investors gravitated towards equities where the dividend yield has been a useful source of returns (in most studies, outside the US, dividends are in fact the main source of long-term equity returns).

Now one could of course just use a handful of big blue-chip stocks to produce this yield within a portfolio but there’s an obvious diversification risk. Funds seem more logical, but which type? Unit trusts are an obvious choice but there’s a hitch as they don’t build up revenue reserves over time and thus their income payout can be volatile.

Trusty reserves

Cue investment trusts, especially those with an explicit income mandate from investing in equities. These can, and do, build up reserves that allow them to smooth out payouts over the long term, progressively increasing the dividend over time.

Back to our 60-somethings. Given they’re interested in stable, progressively increasing income payouts, why wouldn’t they use a diversified portfolio of generalist, mostly global equities-orientated investment trusts to generate a stable income?

That’s certainly the approach taken by Doug Brodie and colleagues at Chancery Lane retirement income service. They’ve been successfully building individual portfolios for clients – typical range from £500,000 to £1.5m with an average age of 62 for a client – using a research shortlist of more than 30 investment trusts with the average initial yield in the 4%-5% range.

What’s fascinating about this approach is that it defies conventional investment wisdom. Conventional wisdom is that equities are riskier and volatile and thus investors are better off with a portfolio of boring bonds, generating income to pay an annuity.

Sadly, until very recently, the income from bonds would have struggled to get close to 4%-5%. More ‘experts’ now think some form of equity exposure later in life, might be an essential component of sensible financial planning.

Natural Income

The next bit of conventional wisdom is that whether you take income from dividends or capital shouldn’t matter. What really matters is the total return (dividend plus capital return). Brodie at Chancery Lane disagrees vehemently. He argues that ‘with equities, a dividend is paid to each individual share; if you sell a share, you will never receive any more dividends from it. If you sell some of your shares every year to generate cash to draw, you will always have fewer shares than you started with at the beginning of the year.’

He prefers to use the natural income generated by fund dividends.

Another conventional approach is to use complex simulations based around capital risk to model a ‘perfect’ portfolio. But Brodie argues that this is overly complex and that the typical individual investor wants something much simpler. Chancery Lane’s approach is to ‘avoid sequence risk by looking for sources of income that have demonstrated minimal “down volatility” for 30 years or more, a period that should be sufficient to cover the lifespan of the average retiree.’

The last bit of conventional wisdom is that investment trusts are seen as riskier than other structures. They can take on leverage, they can use their balance sheet more creatively and they have boards of directors who might push a fund in a different direction than intended by a portfolio manager. But, again, Brodie at Chancery Lane disagrees. Given that his clients want a stable, growing dividend income from equities, generalist investment trusts – with their boards, revenue reserves and leverage – provide exactly what most clients need and want.

Dividend heroes

Brodie points to internal research which shows that in the subgroup of generalist investment trusts the dividend payment was the same or higher than the prior year in 97% of cases. In 89% of cases, it increased every year. According to Brodie, ‘stretching back to 1974, the major generalist investment trusts demonstrated a 100% track record in paying annual income and an 89% track record in continual annual dividend increases’.

‘Of the major trusts we tracked, the payment record remained at 100%, with only one making a reduction in 2020 – Temple Bar (TMPL) reduced its payout by 25%,’ he says.

In addition to the usual research metrics on funds, Chancery Lane focuses on those crucial revenue reserves. ‘It is the ratio of reserves and income to dividends that allows investment trusts to maintain and increase dividend payments throughout market turmoil,’ explains Brodie.

Generally, Brodie expects to see at least 60% of the annual dividend covered, so long as there are plenty of revenue reserves on the balance sheet. Some funds continue to shine – Brodie namechecks Murray International (MYI) or Merchants (MRCH) – while others like Lowland (LWI) fall out of favour over time because of that focus on revenue reserves. Brodie also keeps a wary eye on the actions and words of boards. He’s nervous of boards that push managers away from a more sustainable long-term approach to paying out dividends.

My own sense is that Brodie at Chancery Lane makes very valid points. He’s right about the need for income stability and he’s right that investment trusts are a valuable tool for advisers – too many ignore trusts at their clients’ peril. I can also see the logic of using diversified, mostly global equity generalist funds with an income mandate, but I worry that this could lead to an excessive focus on a narrow bunch of equity sectors, with all these generalists herd into a small number of fashionable sectors.

What about bonds?

If I had a blank sheet of paper now, many corporate bonds with their higher yields might look very attractive, and thus ignoring bonds might also have its downside. Brodie acknowledges this and says he has used bonds extensively in client portfolios in the past but is ‘not yet’ at the stage of buying into many bonds.

One final concern is that the fund selection skills of the team at Chancery Lane falter and they simply pick the wrong investment companies using the wrong metrics, which is the classic criticism of all things active.

My only other observation is that the average age of clients at Chancery Lane with a portfolio is just 62. I’m increasingly of the view that investors need to delay taking an income until they are much older, possibly in their late sixties and thus take on more market risk in their early sixties. The idea here is to build up more capital which can be used to generate that income slightly later in life, and that a switch to equity income in the early sixties might thus be a tad premature.

But I concede that I am probably something of a contrarian in this regard and that many would be much more cautious than I am when they hit 60. Still, I think the main point that Chancery Lane makes is spot on. Why wouldn’t investors use sensible, well-managed generalist investment trusts to generate an income in retirement?