The future of income investing: Taking a Total Portfolio Approach

CHRIS THOMPSON: Yeah, hopefully you'll have some subtitles for the video. Yeah.

SOPHIE TENNISON: In this episode we're going to talk about income. So a topic that many investors will feel comfortable with. But the questions that we're guessing for investors are changing. So obviously we've got defined benefit pension schemes. They're looking to meet their pension payroll defined contribution members are looking to transform their savings pots at retirement into an income for life.

And then we've got wealth investors that are looking to develop a stable income that's going to help, uh, hedge against inflation and, um, other market conditions. Ben Johnson and Chris Thompson recently published a article called a Rethinking Income Investing A Total Portfolio Approach. And I've included the article in the show notes of this episode.

So really glad you could join to discuss that in more detail and really explore some of the themes there. Ben is a strategic advisor, and he's one of the architects of our Think Act Invest framework, which hopefully some of our listeners saw a previous podcast on. And Chris is one of our DB portfolio specialists.

So he's working on portfolio construction for some of our largest DB run on portfolios. Would you both like to introduce yourself to our listeners, and maybe give an outline of the role that you have at WTW?

BEN JOHNSON: Well, thank you very much for having me. I'm looking forward to this. Um, so I'm a managing director at WTW. I've been here for coming to 17 years now, I think. Or over 17 years actually. And I spend a lot of my time advising DB and DC investors. So helping them think about ultimately what they're trying to achieve.

Think about what risk means. Think about what opportunity means for them, and then building a framework and portfolio approach that gets them to deliver it ultimately.

CHRIS THOMPSON: Yeah. And thanks again for having me. It's great to be on the pod, to be honest. Um, yeah. So I'm a portfolio manager within our delegated investment business, and I think you did a great job introducing me in my role. Um, I do spend a lot of my time thinking and constructing portfolios for some of our biggest clients that are focusing more on, run on and, and income focussed portfolios.

SOPHIE TENNISON: Brilliant. Well, maybe I'll start with you then. Chris, obviously you're having a lot of conversations with investors about income, but what's changed in terms of the questions that you're getting and the conversations you're having.

CHRIS THOMPSON: Yeah, I mean, it's I think it's fair to say quite a bit. It's changed in the, in the, in the last few years hasn't.

SOPHIE TENNISON: Gotten an easy question.

CHRIS THOMPSON: Yeah, absolutely. Um, no. We've seen, um, markets change. We've seen material increase in, in in yields. We've seen strong equity market performance. So what that has meant for most schemes is that their funding levels, their position has, has, has accelerated. And they are now ahead of where they expected to be at this point in time.

And then when you combine that with, um, other changes that we're seeing, sort of legislation changes around, um, extraction of surplus and um, the sort of DB funding code. I think the, the discussion about the, the strategic objectives are just becoming more and more important. And it's important to get those clearer outset before you even start thinking about making those portfolio decisions.

Um, obviously sat next to Ben here, so it'd be remiss of me not to mention, I think, acting best, but I think one of the key principles there is that making sure that any decisions you are making from a portfolio perspective are sort of anchored to that, that strategy and those objectives. So, um, yeah, once you've got that, that clarity of that strategy, um, and how trying to achieve that with confidence, it's sort of it's clear why schemes are focusing more on income, more unpredictable income streams, um, to give you that confidence to achieve those, those outcomes.

BEN JOHNSON: I guess you build on that a bit because the, the DB context, if we think about DC investors, you've effectively got the first wave of members who are going to have exclusively DC benefit and state pension as well, but those members are retiring now or retiring soon. And if you just think about those individuals, they've spent their whole lives, I guess, turning up doing the day job, getting a paycheque, probably thinking they have to turn off to turn up to the day job to get the paycheque, but they haven't had to think that hard about it.

And they're getting to the point now. They're retiring, got this big pot of money. They've got to turn that big pot of money into that reliable, resilient income that will last them for the rest of their lives. And I think that's a really difficult challenge because that's an investment question, and it's an actuarial question.

And you spent your whole life specialising in one thing, and you're now being asked to be an investment in actuarial expert. And I think that's really difficult. And so when I think through the kind of considerations that the having to battle with of sequencing risk, longevity, thinking about investment risk, thinking about cash flows, liquidity, all these kind of things.

It starts to sound to me a lot more like a, a DB problem. Um, and I often think, yeah, if you kind of wait a long wait long enough, everything comes back into fashion. And my life often says that's probably true about my wardrobe as well.

SOPHIE TENNISON: Maybe we'll get more viewers flipping over to YouTube now to check out your wardrobe.

BEN JOHNSON: Yeah, I should.

SOPHIE TENNISON: Have made that song. Really lean into it. Yeah.

BEN JOHNSON: Subtitles. Flat caps and whippets.

SOPHIE TENNISON: I'm mindful that some of our listeners, when they will have seen the title of the podcast and might be thinking more around cash flow driven investment and expecting us to be talking about that. And I guess I'll be interested to know, under that kind of regime, how a well funded DBS scheme would have invested and how what you're talking about today is differs from that.

CHRIS THOMPSON: Yeah, sure. So I think where we've been historically is that schemes have been targeting this self-sufficiency funding level. And when they've been getting close to that or past it, um, we've seen schemes taking risk off or more like actually just taking return off and reducing return quite, quite materially.

Um, so what that's meant is that they've been focusing on assets, gilts and credit to more precisely match what their expected liability outflows are. Um, and whilst as consultants, we like the illusion of precision. I think it's fair to say that, um, liabilities are far from that. They the sort of the, the actual expected the actual experience will be different to, um, what we expect.

So you sort of don't want to construct your portfolio around something that's just sort of relatively imprecise. So we think whilst there are a lot of good things and foundations from the CDI framework, I think the question just needs to become more broader. Um, and it comes back to Ben mentioned it earlier.

It's just that sort of resiliency point. And how do you make sure that the portfolio is resilient enough to achieve those those outcomes with confidence. So you start asking yourself more broader questions of it's a portfolio. Um, sufficiently diversified is the income, is the income stream a truly diversified source.

You have you got sufficient flexibility, one within the portfolio to take advantage of opportunities. But do you have the governance framework in place in place to do that? So once you once you combine all of that, that puts you in a, in a better, better place from where you were. And it's just an evolution of those, those concepts that we had from a sort of portfolio construction standpoint.

SOPHIE TENNISON: I guess that makes sense in terms of not wedding yourself to precision. I know we've all had conversations with schemes around all those risks that can take you off, that we can't model, no matter how good we are. Yeah. No, it's it's not investment risk. That longevity risk expense is changing all that thing kind of really data cleansing all that can kind of change the ballpark.

So ballpark. So if you are trying to wedge yourself to one specific out, you know, number then then these things just are.

BEN JOHNSON: Going to be wrong.

SOPHIE TENNISON: Yeah. Exactly. Exactly. Yeah. You mentioned resilience there Chris. And obviously the regulator is really keen on schemes, thinking about strategy in a resilient way, making sure that it can cope with different market outcomes. I guess maybe I'll come to you now in terms of thinking about resilience from an income perspective, what do we mean by that?

Is it just a case of just maximising the amount of income you can get from assets?

BEN JOHNSON: Yeah, I think I don't put words in the sweeping generalisation, but maybe I will actually. I think when people think about income stability of income, I think what they're really getting at is an income that can adapt, that can support me through time throughout the whole journey, throughout my retirement.

And so I tend to think of it as, yeah, kind of if maximising income is out of the snapshot. Resilience is such easy, but resilience is sort of the journey. It's making sure that that income stream will continue to support the objectives, will continue to do what you need it to do all the way through. It'll protect against inflation, whatever it might be.

That's why that's where I come from. I think it's the distinction between the snapshot, which might be stability objective and the journey, which is the the resilience angle.

SOPHIE TENNISON: So what would a scheme need to do to to kind of be ready from an income perspective.

BEN JOHNSON: I think yeah. So Chris has mentioned the you've both mentioned it's the think act inverse frame, which I'm sure listeners can pick up on the other podcast. But the kind of one of the key principles underpinning all of that is you need to start first with what are we looking to achieve? Because you can only build something that's really resilient to manage the risks.

If you first know what it is you want to do, and then only then can you quantify what risk is, because risk in its most simplest term, we've got all these tracking errors of value at risk. All these measures, they're useful. But the true measure of risk is I can't do what I wanted to do and what I set out to do. So we want to start by asking that fundamental question of what we here to do.

What then does the rest look like in that context? Then we can start thinking through some of those things. And I think when I look across from I'm talking from the strategic perspective, I'm sure Crystal touched on some sort of more, more portfolio aspects. But when we think from a DB client perspective, we want to build resilience.

The natural tendency is to think, well, that's a stability point. I'll reduce investment risk because I can make it more, more stable. But you mentioned, Sophie, that investment risk is but one of many. There are a whole lot of other non investment factors. Um, we just don't everyone doesn't know individually and collectively how long people are going to live.

There's a longevity risk. We talk about the risk of people living longer, which sounds perverse in the real world, but in pensions world, that's the way we kind of think about it. And so you don't reduce that risk by selling some equities. You reduce that risk by hedging it, or you manage that risk by building a buffer so that if a bad event happens, you can absorb it.

So where we get to in that is from an overall resilience perspective for the strategy. low risk is not low return. A moderate return is higher resilience. So that's kind of a headline DB strategy, a thing I guess from a DC perspective. And the individual kind of wealth perspective from the DC angle primarily, is that you can think about some of these things in the design.

So I think you've touched on you've done sessions on podcasts, on collective, DC, on flex, then fix things like annuities can help provide that stability. Things like pooling and investment and longevity risk can certainly help. Um, but I think, yeah, there are a number of things there to think about.

In the final thing I would just say is that that having that clarity on what you want to achieve, understanding what risk means in that context, and then putting the governance framework into deliver, it is really key.

SOPHIE TENNISON: And that makes sense. I guess one of the other key themes that's in the article that you published was around the total portfolio approach, and appreciate this has got more traction. It's got more, um, traction in the press in terms of what it is, but it might be worth just for all our listeners just to cover off again what we mean by a total portfolio approach.

Um, but also, I'd be interested to hear how that framework can support trustees and how they're thinking about strategy specifically.

BEN JOHNSON: So I think when I think about it, I kind of come up with sort of three, three points that I think are really important for how how we build a sensible and resilient portfolio. And the first of those we've kind of touched on a few times already, but it's objective led portfolio construction. So it's again being clear on what the objective is and then making sure that everything in the portfolio is there specifically to deliver that ultimate objective.

And that sounds really obvious, but we often start from the answer appears to the portfolio and kind of work back and anchor and adjust it. You're going to arrive at very different outcomes for how you build a portfolio. Obviously, you can do it between CBDC individual investors. can derive a DIF outcomes, but different DB investors, different DC investor will end up at different positions depending on what the ultimate Jet2 is.

So that means a really key thing.

The second thing is, is this kind of competition for capital. It's like a weird way of putting it, but maybe it's the it's almost one in, one out or every investment have to earn its place. And that you think about the portfolio as a number of ideas, income generating ideas that are trying to are vying for that position in your portfolio.

So if something else comes in, it's better than what you've got. It can bump it out of the portfolio. So that kind of competition for capital mindset thinks important. And the final thing I'd say is just adaptability. And we've mentioned a couple of times. Yeah you've got these. Someone in a DB sense, someone will draw you this perfect cash flow chart.

You know, that's just a reflection of that's just an illustration of some abstract. Yeah. Reality is a whole lot of assumptions going into it. So we need to be prepared to adapt and refine that that portfolio over time. And I think the final thing I'd just say is that it's almost income isn't a it's not an asset class.

I think we need to move away from that. We need to think of that as income is kind of an objective. And then once we've got that, we can be much, much clearer in how we build the portfolio. But those are those will be the three things. So I've rambled on a bit there, Sophie a bit.

CHRIS THOMPSON: Yeah. And I think how sometimes I'd like to think of it, I like to do, like to try things in the spark context. And we've fresh off the back of the World Cup, um, start of the football season. So apologies to any, uh, non-football fans here, but here comes a football analogy. But, um, when you think of, um, the sort of total portfolio approach, if it's if you think of a total, total football, um, what you're looking for is a team that's, that's flexible.

You're looking for a team that can adapt to changing conditions. You're looking for players that can can move around that aren't necessarily rigid to a particular position in the portfolio and portfolio in the team. Um, whereas the more traditional way may have been more of late. Or to have your big striker at the top who can, um, has has only a single role to play.

So I think that when you put that into context of what Total Portfolio is looking for, it's you wanting just that, that ability to yet compete for the right places. And, um, make sure you have that flexibility to, to adapt.

BEN JOHNSON: And change tactics mid-game.

CHRIS THOMPSON: Yeah, absolutely.

BEN JOHNSON: Bring on subs. It's competitive. Yeah, I think it works.

SOPHIE TENNISON: I'm glad you both think so. I'll be googling FourFourTwo after this. Yeah, but could you give me a practical example of how it actually works in practice in the portfolio construction space?

CHRIS THOMPSON: Yeah, sure. So on the I suppose on the DB theme. So a more sort of traditional thinking, um, from a liability hedging standpoint, um, the traditional question might have been what assets can I buy to match the benchmark that I'm measuring, um, my liabilities against. And for most pension schemes that it would likely have been buying a large proportion of UK government bonds.

Whereas with a more total portfolio mindset, you're you're starting with, well, actually, what are we trying to achieve overall and what are the total risks that we're managing. As Ben's already alluded to. So once you start thinking from that perspective, um, you could end up with a portfolio that is in a totally different place to where you where you would naturally start.

You might end up in the same place, but you've at least gone through the right challenges to to get there. So you you again, one thing that you've discussed on the podcast previously is just, um, UK government bonds aren't necessarily no risk or low risk. So it's something to that's once you bring that into consideration alongside the value of assets and that that can offer to achieve what you're looking for from your liability matching assets.

Pulling that together, you do likely end up in a different place versus where you would where you would be. And it's not about sorry. It's not about, um, sort of maximising the or the minimising the tracking error versus a benchmark and your actuarial basis. It's maximising the probability of achieving that, that outcome that you're looking for in the, in the longer term.

Um.

BEN JOHNSON: That's a good point. I think just thinking from a another example, maybe from a growth portfolio or a return seeking perspective, albeit given with gilt yields where they are, you could question whether that's a return seeking asset, but that's a topic for another, another time maybe, or not entirely.

Um, but if we think about yeah, think about another asset. Let's, let's we talked about TPA not total portfolio approach not being a rigid framework. If people are following a very rigid strategic allocation framework that they've set a couple of years ago, and you get something like an idea, let's think of insurance linked securities.

What I'm talking about here are effectively bonds like corporate bonds where you get paid a premium like you would do with a bond, you get paid an interest payment, and then you get your money back at the end in a bond, if the company doesn't default, you get your money back in an insurance contract. If negative insurance event doesn't happen, perhaps an earthquake or a hurricane or whatever it might be.

So from an income perspective, to me that looks very like corporate bond. It's something that's paying a regular income, and I get my principal back at the end. As long as the bad event doesn't happen, it's very diversifying because stock market crashes don't cause earthquakes, aside from, I guess, metaphorical ones.

But if you've got a very rigid framework that you've set that puts things into certain buckets and something like this doesn't neatly fit into those buckets, then it gets excluded, Potentially. Whereas if you start from the perspective of what is my objective, I need to generate some income to achieve this mission.

I've got assets that are competing for capital, so this is better than something else that's already in there. It can boot it out. And equally I can adapt to the portfolio over time, whether that's changing returns, whatever that might be. You maybe arrive at a different answer.

SOPHIE TENNISON: I guess there's some. For some investors, a strategic asset allocation will be familiar and probably feel quite simple to an extent. And I guess one of the challenges I can see posed a total portfolio approach type mindset is this is more complicated. This is going to increase the complexity within the portfolio.

I guess, could you speak to that? Is that is that true? Is that the case?

CHRIS THOMPSON: I mean, I can certainly see that as a, as a viewpoint. Um, I mean, I think one of the things that the total portfolio approach at least starts with is making sure that when you're thinking of investments, you're looking for the best assets and you're making sure you're

CHRIS THOMPSON: at least looking at a starting point across the full opportunity set. Um, and I think that's, that's a positive and something that could be a value additive to, to schemes, but that could then be seen. Yes, that could be more complex because you've got different ideas in. But I think that complexity shouldn't be assumed to, to add value.

I think any new idea that comes into the portfolio needs to pass a burden of proof. And I think that that level of proof will be different for different schemes just because of their beliefs, the governance frameworks that they have in place. But I think the steps are important, and it's making sure that then any investment that you are making and wanting to make, it's able to prove is it improving the portfolio versus the objective that we're looking for, given all of that, that that context?

CHRIS THOMPSON: I mean, equally on the other side of things, I think if you have a more of a static portfolio, it's unlikely that one manager, one asset class, one strategy over the longer term is going to always be the right place to be. And they're not going to be the sort of monopoly of good ideas as such. So, um, it just places that importance of actually being able to source good ideas, um, and find those attractive opportunities that fit within, within, um, client portfolios.

Um, and I think that's one of the important things alongside then actually allocating to them and the sizing of positions. Um, so the sort of portfolio approach isn't necessarily it's not about being the most complex, it's about finding those best opportunities and combining them together to help give that confidence of achieving those outcomes.

Um, given the constraints and the context that we're working with for, for clients.

BEN JOHNSON: And I mean, you can't end up, uh,

BEN JOHNSON: You, kind of you kind of end up at an extremely simple portfolio. If credit spreads were higher than they were right now, you could load up and that would be that'd be great. I think it's just it's just being clear on. So I think one of the things that I mean is someone we used to work with, um, used to have a phrase which I've kind of probably both adopted as a mantra, which is as simple as possible but as complex as necessary.

And I really like the way the kind of burden of proof point, I think. Yeah, it can't be complex for complexity sake. It has to really, if you're going to do something more complicated than a simple alternative, it has to be justified. But that doesn't mean you shouldn't do it clearly, because if you can achieve do something that is more aligned with achieving that ultimate objective minimises the risk of mission impairment, and you've got the governance capabilities set up to do it, then that's something we should challenge ourselves to think about whether we can.

SOPHIE TENNISON: Yeah, that's really interesting because I think Like what you're saying, but it doesn't necessarily mean you're going to end up with a completely different portfolio. This could just be a tweaking around the edges or thinking about something new and fundamentally twisty. Beliefs and preferences would be driving all those discussions anyway.

Yeah. So. So if trustees did want to adopt this way of thinking, what are the types of questions they should be asking themselves or their advisors when they're reviewing the portfolio?

BEN JOHNSON: Yeah, I'm starting at risk of being the broken record, but I might as well be is that I do come back to that first. First question is just trying, and it can be difficult to answer it because there is a desire to keep be flexible, but having clarity on what you are looking to ultimately achieve, what is the purpose, and then be able to think about what risk is in that context.

Very practically, I think is really helpful. And then trying to be practical about risk. So one of the things when we've done it with a few clients but is think about reverse stress testing. So in the old world we used to sort of get a starting point project forward and arrive at a future outcome, which you mentioned at the beginning.

Many kind of DB schemes are kind of at that sort of future outcome. And so the big question trustee boards need to ask themselves or one of the big questions is what what's painful, what what's what could hurt us from here. Think about what that could be. Maybe if you're a well-funded DB scheme that could be a 10% funding that'll drop that tips you into deficit, ruins your surplus.

Sharing plans requires company contributions. Think about what are the events that could cause that fall? Are they plausible? Get the history books open and then have a practical conversation about do I need to do anything differently result. And that's kind of to my mind, that's a really pure expression of that, that mission impairment point.
There's a whole lot of I mean, you've probably again rambled on, but you've probably thought of the killer question in that in that time. Chris, I don't know.

CHRIS THOMPSON: Yeah. I mean, I wouldn't necessarily call it a killer one. Um, the one might be it might be lucky if it's a knockout one, to be honest. Um, no, I think it comes to. The assets that you're holding and what role are they playing in the portfolio and are they pulling their weight? Um, and in the context of thinking of the, the sort of the income that it's offering, is that sufficiently then diversified across the sources of, um, of income and, and the borrowers that you're sort of dealing with?

SOPHIE TENNISON: That's really helpful. Um, I think there's a lot of things that trustees do need to kind of work through here. But actually, when you think of it on that level, it's relatively simple questions and probably easy ones that you can revisit. One of the, I guess, one of the other key themes that comes out in the article is the framework that you've established.

Um, Snapple named, uh, tilt rotator increase. We always love a three word framework in WTW and.

BEN JOHNSON: Give them the name. Yeah.

SOPHIE TENNISON: Exactly. Um, but that framework you go on to describe in the article how it can help trustees constantly kind of evolve and review the strategy over time. So just wondering if you could just outline that in more detail of how in practice, trustees can use a framework like that to review strategy in different market conditions?

CHRIS THOMPSON: Yeah, sure. So, um, the tiltrotor increase or the, uh, the trifecta? Um, yeah, I think.

BEN JOHNSON: Ride it all the time.

CHRIS THOMPSON: Yeah, yeah it does. Communities in transfer market, etc. to to change and add players to the, to the system. So bringing that into the context of what that might mean from a, from an investment perspective, if you think of well from a, if I'm looking to sort of tilt it, that might be within asset class and change the sort of tactic rotate maybe meaning actually I want to change from one area of the market to another.

It's something that we've seen done quite a bit across our client base recently, just linking to what Ben said earlier about, um, insurance linked securities. It's an area of fund. attractive particular time when traditional credit spreads have narrowed materially. And the final one on this of the increase side of things, it's making that

CHRIS THOMPSON: One it's been able to and being ready to and having the flexibility. But it's been having the the framework in place to be able to to take advantage of opportunities in the market to, to increase positions if necessary. And that links to investment grade credit. Again, it's an area we've seen and taken advantage of over the last 5 or 6 years when there has there have been spikes in credit spreads, whether that be, um, for example, during Covid or more recently, um, and it's just being able to take advantage of that quickly to and increase those positions.

SOPHIE TENNISON: And you mentioned there about kind of taken advantage of, of market conditions or things happening, which obviously we know doesn't always neatly fall into a quarterly cycle of meetings. Um, so just thinking more practically, how can trustees be ready to take advantage of these market changes when they aren't happening at perfect time points?

BEN JOHNSON: Yeah, I won't. I'll make a point of not repeating my kind of yeah, I haven't gone on doing a mission risk thing, but I think you it's very difficult to capture opportunities if you're starting from a blank sheet of paper all the time. So I think you've got to be very clear on what you're looking, what you're looking to do.

And then you can set out the framework for how those decisions can be made and whether that is subgroups of trustees, whether that's delegation to certain entities or whatever that might be. But I think it's first of all, it's thinking about those objectives, thinking about that governance framework and not starting from a blank sheet of paper every time.

Because frankly, it's just, yeah, the world doesn't work to quarterly meeting cycles, does it?

SOPHIE TENNISON: And I think that governance, that strength of governance is always an important thing that we come back to with any kind of conversation around strategy is that, um, well, we've had a really good conversation. So thank you both very much. But I just wanted to finish with one final question and maybe challenge you to stick to one sentence.

But what

SOPHIE TENNISON: Mistake do you see investors most likely making when it comes when it comes to income investing?

BEN JOHNSON: That was definitely a dig, wasn't it?

SOPHIE TENNISON: I think it kind of just a lot.

BEN JOHNSON: I think it was nothing at all. In two sentences and three I come back to, I stop thinking of the income as an asset class. Think of it as a requirement. And if you kind of take that mindset, you have a much broader perspective on how you can build that portfolio. And I think the portfolio would be built more effectively. Five sentences, maybe six.

CHRIS THOMPSON: Um, I'll go for two. Uh, so mistaking a predictable income stream for a resilient one, um, I think you can have a highly predictable income stream that can fall still short of what you're trying to achieve.

BEN JOHNSON: Definitely wasn't too.

SOPHIE TENNISON: Well. Our listeners decided to comply with that question, but it comes back to, I guess, the objective, every asset having a role and being able to adapt to market environment. So thank you both so much for the conversation. It's been really nice to have an excuse to do it in our hometown. So that's been really good.

Awesome city I should say. Um, and thank you to our listeners for joining us today, and hopefully you can join us for another episode of Pensions Perspective Podcast, brought to you by WTW. Thank you very much.

SOPHIE TENNISON: Thanks for listening. This podcast is for informational purposes only and does not constitute financial advice. The views expressed by any hosts and guests are their own and may not reflect those of their employers or affiliated organisations. All content is protected by copyright.