A Holistic Approach to Creating High Income Portfolios That Are Risk–Return Efficient and Tax Aware

Abstract

Retirees and other investors may prefer to use dividends from equities and interest from fixed income to fund their spending needs. This mental accounting phenomenon of spending the portfolio’s income without drawing down the invested principal makes them seek high income–producing asset classes. These investors, either directly or via advisors, adopt static high income portfolios as an investment strategy, often ignoring risk–return efficiency and tax efficiency principles. In this article, the authors introduce a methodology to systematically construct high income portfolios through an expected utility of wealth maximization approach while allowing for the incorporation of an investor’s income preferences. However, because asset return expectations are conditional on asset valuations, the authors find that popular static high income portfolios that are created on an ad hoc basis—by substituting broad market exposure with high-yielding assets—by design are not optimal. More importantly, the authors find that high income portfolios are tax inefficient when it comes to high tax bracket investors, making their use only appropriate when taxes are not a primary concern—for example, for low- to moderate-income investors or in a tax-deferred account.