In the second of a series of four research papers on income investing (we published an extract from the first last week), Legg Mason says that, for retirees in particular, sticking to the “well-worn path of term deposits and annuities” may not provide the desired outcome.

“When taking inflation and longevity risk into account, it is clear that income investors should diversify,” the paper says. “Now is the time for income investors to rethink their approach to investing.”

This will mean a big shift, for many investors, in the way they approach portfolio construction. It will mean a shift away from managing asset class segments compared with a standard benchmark. It will mean grappling with the main challenge for income investors, which is the sustainability of their income.

The paper, ‘Broadening Your Horizons – Income Diversification Matters’, says that income investors should consider more “equity income” investments, such as yield stocks, and more “real income” investments, that include alternatives and property.

Interestingly, the paper also suggests that the famous home-country bias of Australian investors, helped by our dividend imputation system, is not as bad for investors as many have said. Australia is a much more diversified economy than it was 10 or so years ago.

The paper says that, with income investing it is paramount to match assets with liabilities, which means it makes sense to invest in those industries that contribute to Australian economic growth. Surprisingly to many, this is not in mining.

Continuing to invest in growth assets, in particular yield-delivering stocks, in a transition-to-retirement period also reduces ‘sequencing risk’, whereby a one-off hit in a market can have a devastating impact on an investor who doesn’t have a long time to recover from the short-term losses (see the Milliman report in this edition).

The full series of four Legg Mason papers – Income Solutions for Life – can be seen on the firm’s website: http://www.leggmason.com.au/income-solutions-for-life/