A common goal expressed by clients phasing into retirement is a desire to invest to generate income to live on while leaving their principal intact. Why? They probably saw it used successfully in the past.
When many of our parents invested, they lived off the interest and dividends from their portfolios, replacing bonds as they matured and leaving their stock holdings untouched.
Why is this approach, often referred to as “investing for income,” or “income-only” investing, not necessarily the best idea for modern-day portfolios?
Why might your advisor suggest a different tactic, and what should you keep in mind when it comes to generating retirement income?
This shift away from employment (and its income) and into retirement or ‘work optional’ mode is an important milestone that is unfortunately often accompanied by anxiety over the ability to sustain oneself for the rest of life without running out of money and becoming dependent on others for financial support.
As a result, often times our instinct today is to do what our parents advocated, to only live off the income and not touch the principal.
The problem is that with interest rates low and companies paying out less of their profits in dividends than they used to, this typically isn’t enough to comfortably live on.
For example: if a client has a portfolio of $1 million, then a reasonable withdrawal per year is $40-50,000.
But if the interest and dividends—both paid out as dividends by the funds—are only producing 2%, or about $20,000, where does the rest come from?
When people are withdrawing from their portfolio to generate monthly or quarterly income, they generally need more than a 2% yearly withdrawal; typically a sustainable withdrawal rate is more like 4-5% per year.
The phrases may sound similar, but they have distinctive characteristics that differ:
Investing for income: A portfolio of assets such as stocks, bonds, mutual funds, and real estate that generates the highest possible annual income at the lowest possible risk.
Investing for total return: The actual rate of return of a portfolio over a given period; it includes interest, capital gains, dividends, and distributions.
Diversifying Helps Account for Inflation
To better describe the concept of total return, here’s a story about two villages, each located close to a river. Both villages growing, thriving, and making do with what they have. One is called “Bondville” and the other “Diversitown.”
Each village needs water to supply its residents for drinking, cooking, and washing, and each village has been experiencing growth in their population... which, over time, has increased demands from their respective water supplies.
In this story, the need for water parallels our retiring investor’s need for income; inflation is represented by the increased demand for water as the village grows.
Bondville prefers to keep their river intact, as they like the freshness of the running water.
In years of high flow (e.g., high interest rates) the water is plentiful and the villagers tend to increase their consumption of water, washing more frequently and planting crops that use more water.
In years of drought (think: low interest rates) they cut back. As Bondville grows (inflation), there are fewer years of excess supply, and the years of drought become increasingly challenging.
Diversitown has taken a different approach.
After accessing their resources, the citizens of Diversitown construct a dam upstream to hold a reserve of water which also allows them to moderate the flow of the river.
Diversitown also digs a well for their citizens to tap into the ground water absorbed by the earth, particularly in years of heavy rain.
True, the water from the reservoir and from the well give up some of the freshness of the running river (which was a priority for the Bondville people). But by diversifying their water sources, the folks of Diversitown have the ability to maintain a regular supply of water for themselves while providing a growing reserve (the reservoir) to help provide for future increases in the population.
There are considerations, merits, and drawbacks to either approach.
Last but not least, recognizing the civic and environmental importance of the river to each of the villages, the town leaders in each of the villages decide to impose a tax on their respective water supplies, imposing a greater tax on water taken directly from the river, and a lower tax on water taken from the reservoir or the wells. (And, yes, the “tea party” factions in both villages are up in arms about the taxes.)
Clearly the residents of Bondville, who derive all their water from the river, are impacted more by the tax than the residents of Diversitown, who gather their water from multiple sources.
Mosaic follows the “total return” approach, as paralleled by Diversitown, because it allows for a more balanced and diversified portfolio, rather than skewing towards those investments which generate high yields.
What else is a diversified portfolio good for?
Diversified portfolios are also favorable for tax planning. And, most importantly, we use a total return approach because it allows us to pay out needed levels of cash to clients who need a certain amount of investment income while still generating enough investment growth over time to have that income level typically grow with inflation.
Income investors often try to maximize their income by investing in higher-yielding bonds and high dividend-paying stocks. This leaves out a large part of the market that gives its returns to investors more through growth in the price of its shares than through paying dividends. Faster-growing companies often pay little or no dividends so they can use their profits to further invest in the opportunities they would like to take advantage of, rather than using a chunk of those profits to provide cash to its shareholders.
Income-only investors miss out on such companies, focusing instead on investing in higher-risk securities for higher yield. As a general rule, tax law favors growth over current income.
Ordinary tax rates apply to most interest and dividends. These tax rates are almost always higher than the tax rates applied to capital gains. Capital gains (growth) are generated when company shares (stocks or funds) are sold at a price higher than when they were purchased.
So, not only are tax rates lower for capital gains than for income received, for the most part, the shareholder has control over when to make the sale, and therefore when to recognize the profits and be taxed on them. This control can be very helpful when doing tax planning.
How come the way our parents did it probably won’t work as well for us?
People are living longer. Similar to the villagers in our fable, today’s retirees face similar issues of balancing their present needs against those of their extended future for a considerable but unknown length of time.
A 2016 study done by the Hamilton Project predicts that 22% of the men who were 65 in 2015 will live into their 90’s and 33% of the women who were 65 in 2015 will do so as well.
The longer people live, the longer they will need their assets to support them for multiple decades post-retirement. A study conducted by the U.S. Census Bureau over 2006-2008 found that 14.5% of the nation’s most advanced in age, age 90 and over, lived in poverty.
Over most investors’ lifetimes, the total return investment approach will help provide for your ongoing needs, retain your purchasing power against the erosive influence of inflation, and minimize taxes, as compared to an all-income portfolio. Moreover, living off investment income and leaving the principal alone tends to skew the way one invests, making the portfolio less diversified.
Mosaic attempts to maximize your returns, while staying within the parameters of your risk tolerance, using funds and being fully diversified while controlling taxes, all so you can enjoy a steady level of growing income over time by using a combination of interest, dividends and growth.
We believe doing so serves you—including your goals and your meaningful nest egg—best over time.