Retirement Income: Can You Get 8% Annual Income And Capital Sustainability?

by: Left Banker


Increasing numbers of people are hitting retirement with income needs that go well beyond the classic 4% withdrawal recommendation.

Retirees are looking for high-yield opportunities. Most recognize that this is a landscape fraught with obstacles and pitfalls.

Closed-end funds can play a key role in building a sustainable portfolio capable of hitting high income levels even in today's yield-starved markets.

Can You Get 8% Annual Income And Capital Sustainability?

When I wrote about Miller/Howard High Income Equity (NYSE:HIE) yesterday, a lot of you took me to task. One commenter called it "worst idea I have ever seen posted on SA." Now, I'll be the first to admit that the fund's first year or so were not the stuff of investing legend, but I continue to consider that there is value in it.

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I can't say I was surprised at the response though (Well maybe a little bit. The worst? Come on now.). I knew when I wrote it that some (many?) would think it off the deep end because of the fund's sketchy history. Perhaps I didn't make clear that this was a speculative suggestion. Perhaps I didn't make clear that I considered it a fund in recovery with a lot of value. Perhaps I could have cited my call on another beaten-down CEF, AGIC Convertible and Income (NYSE:NCV), which also brought out the angry villagers but has been paying me over 12% while gaining another 10% since last fall. Anyway, you can put away the torches and pitchforks for now; I'm not going to return to HIE directly here. I'm only mentioning it because some of the discussion got me to thinking about opinions and misconceptions (in my view anyway) about CEFs.

The discussion on that and a few other articles recently brought home some of the issues people have against closed-end fund. I'm going to try to address some of those objections and, in the process, attempt to make clear how I approach this investment class.

First and foremost is that closed-end funds are income investments. There are exceptions scattered here and there in the CEF universe, but the overwhelming majority are created, managed and owned for their high-income production. It is possible to generate capital gains by trading CEFs, and there are those who do a good job of it. That's not my approach. Furthermore, I am of the opinion that for capital growth one can do better, with a lot less effort and a lot better tax-efficiency than trading CEFs.

To successfully grow capital competitively by trading CEFs an investor has to rigorously monitor the market more or less continuously. Discount, premiums, Z-scores, sector allocations: these have to be watched, monitored and acted on as imbalances arise. It's a lot of work. If you're inclined to putting in that constant effort, I submit that you could do better elsewhere. For me, occasional monitoring of these sorts of metrics is something to do when I'm looking for entry points. But once I buy a fund, my intention is to hold it for an extended period, because my goal is to generate dependably high levels of income.

But even the growth-oriented investor can do well with CEFs by reinvesting the distributions. As I've shown again and again, total return (i.e. with reinvested distributions) for many of the funds exceeds that of the index benchmarks. Just last week I showed how a simple portfolio of three equity CEFs with reinvested distributions beat the S&P 500 by a meaningful margin (8.3% vs 7.4% over the past 10 years).

Let's return to income. I've come to believe that some income-seekers are not really well informed about how to evaluate income investments. Not all, by any means; not even a large fraction, but enough that I think it's real. I'm by no means expert on the nuances of high-income investment, so I'm going to try to keep this simple and straightforward. Perhaps too much so for many readers, but for those, I beg your indulgence and ask that you bear with me.

First thing to realize is that CEFs are paying twice to three times the income of S&P dividend stocks, and more than most REITs and MLPs. That's obvious to all, but sometimes the implications of that scale are overlooked. The three-fund CEF portfolio I referred to above is paying a 9.4% yield. A top dividend ETF, Schwab US Dividend Equity ETF (NYSEARCA:SCHD), is paying 2.78%, less than a third of that. "But," some will say, "SCHD has gained 71% vs a equity CEF like Tax-Managed Buy-Write Opportunities (NYSE:ETV) 30% over the past five years." Of course it has. But, if we delve into it a bit we'd see that with that 71% vs 30% price return, SCHD and the three-fund CEF portfolio are essentially in a dead heat.

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Yet my writings on CEFs are rife with commentary such as that as the lynchpin argument for why one should avoid high-income CEFs. The problem is that view does not consider the CEF's strong suit, income. Are people are so used to looking at basic price charts that they become fretful over what they see when they look at CEFs? This despite the fact that the very reason they are looking is because of the high yields?

So what happens if we add income into the mix and reinvest the distributions for both choices?

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Of course, ETV is a top fund coming off a good run. But I didn't just pull it out of the air; it's my second-largest holding for CEFs. But it's only one fund and may be an anomaly. So let's add my largest CEF holding PIMCO Dynamic Income (NYSE:PDI), a fund I've been bullish about since I started writing about CEFs on SA. PDI comes up a bit short of five years old, so I've shortened the scale to 4 years. And, while we're adding, we might as well throw in my number three as well, EV Enhanced Equity Income II (NYSE:EOS).

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I have frequently said that I consider PDI as the best choice for fixed-income high-yield. That could be hard to understand if you only look at the top chart where PDI looks even worse, much worse, than ETV did. That is probably a fairly typical chart for a good performing, fixed-income CEF. But you can see why I like it on the bottom chart. It's the top choice when income is reinvested, beating or matching the equity funds even over a strong bull market. That is, of course, compounding; but even for those taking out 8%, PDI is still an impressive performer, solidly hitting the 8% income, sustainable capital goal.

The difference between price appreciation and total return is Income Investing 101, so how is it that so many readers don't get it? Is it simply a result of not looking beyond the price charts?

Finally, let's add a lower yielding fund. I'm going to choose Reaves Utility Income (NYSEMKT:UTG) to add some diversification, and because it's a very popular fund with many CEF investors. It's not one I own but it is high on my list as a fund to add when the entry looks attractive, so I've been thinking about it.

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You will notice that UTG has the second highest price gain of the CEFs. Even so, it's still less than half SCHD's. And it's the first of our funds that lags SCHD in total return as well. It gives up 2 to 4 points to the other funds on distribution yield, which make a big difference when they are compounding, and shows how impactful those high yields can be.

Here are the funds' current market distribution yields:

The average yield for these four CEFS is 8.01%. It's just a coincidence and something I didn't set out to target, but one of the things I'm frequently asked is if one could reasonably expect to generate 8% retirement income and maintain a stable capital base from CEFs. Let's use these funds as an example of a portfolio that generates exactly that yield.

Here are the last four years history of that portfolio compared to SCHD. The charts are based on $100,000 invested 48 months ago in either SCHD or an equal-weighted portfolio of ETV, EOS, PDI and UTG with no rebalancings. There is no compounding of the yield because the distribution are not reinvested. They are real income; the stuff you use to pay your bills and buy your treats.

These charts show the four-year history.

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As we see, total income for the CEFs is 42.6% of the initial $100,000 invested and that stake grew by an additional 16.3% beyond that income. SCHD did quite well, growing by 51% and putting out 14.7% in dividend income. Combining the totals shows a near wash with a slight edge to SCHD which is only to be expected from its larger cash base available for compounding.

Consider it. A $100,000 nest egg would have provide an income averaging $10,661 a year with no loss, indeed a 16% gain, of the invested capital.

I submit that an 8% income with sustainable capital is not an impossible goal for an investor willing to put in the effort to select a diversified portfolio of CEFs. By carefully choosing top-quality funds and buying them at opportune entry points it is likely that one could achieve comparable results. I'd further add that avoiding things like energy, commodities and cyclicals generally is probably a good premise for the core of such a portfolio. They can be seductive on the upswing, but it should be clear to all where that can go. Many of us, myself included, have learned that lesson the hard way over the last couple of years. Nibble a bit on the edges if you must, but avoid over committing no matter how powerful the sirens' call becomes.

One last point. What happens if distributions are reinvested? SCHD grows to $168,670. The CEF portfolio grows to $167,494.

You'd think I'd set it up.

Disclosure: I am/we are long EOS, ETV, NCV, PDI, SCHD.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I may initiate a long position in HIE over the next 72 hours. To be clear, if I do so it will be a speculative call, and not remotely recommended as a complement to the type of investment I describe here. I am not an investment professional and this article does not constitute investment advice. I am passing along the results of my research on the subject. Any investor who finds these results intriguing will certainly want to do all due diligence to determine if any security mentioned here is suitable for his or her portfolio.