Retirement Income Strategies: The Total Return Approach | Charles Schwab

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Retirement Income Strategies: The Total Return Approach

September 17, 2015

When it comes to thinking about income in retirement, many investors embrace the adage “never touch the principal.”

But however much you agree with the strategy in theory, it can be very difficult to enact considering today’s historically low interest rates. “Given the size of portfolio you’d need to generate a decent income solely from interest and dividends, it’s just not a realistic option for a lot of investors,” says Rob Williams, managing director of income planning with the Schwab Center for Financial Research. 

Instead, you might consider an approach in which you generate income by actually selling assets as well as collecting regular interest and dividends. It sounds contrary to standard wisdom, but a total return approach can mitigate some of the risks inherent in a wholly income-oriented portfolio and help create sustainable growth for a longer retirement

What does “total return” mean?

Total return includes price growth plus dividend and interest income. “There’s no need to constrain yourself to an income-oriented portfolio when the market can give you returns in different ways,” Rob notes.

Incorporating both yield and price appreciation can help smooth and increase your income stream, despite inevitable fluctuations in the market.

If that sounds risky, take heart: Today, most institutional investors—university endowments and pension plans—follow a total return strategy to meet their funding needs, making their portfolios less susceptible to the vagaries of the market. You can do the same. Here’s how to put a total return strategy into practice.

A total return distribution strategy

“The first step is to choose the right mix of investments to provide properly diversified sources of return,” Rob says. “You need income from more stable investments as a baseline, supported by stocks for growth potential.”

Next, sit down with a professional to determine how much income your portfolio is likely to produce each year through interest and dividend payments. Compare that to your yearly income needs. The difference between those two amounts is what you’ll cover through the sale of assets.

In many cases, Rob says, that gap can be closed by doing nothing fancier than rebalancing once a year. Rebalancing involves looking at the percentage of assets in your portfolio—stocks, bonds, cash, etc.—and selling those that have grown beyond the percentages you set when you established your plan. 

For example: Let’s say you’re retiring with a $1 million portfolio, and you need $50,000 from it each year to supplement your other sources of income (Social Security, pension and so on). In the table below we’ve assumed a moderate allocation, with $50,000 in cash to start. Throughout the year you’d spend from your cash reserves so that your cash allocation would be at $0 by the end of the year.

Chart 1: A portfolio shifts from its targets over time

In this example, you would also have some growth in your domestic equity and fixed income holdings by year’s end. As you can see in the table below, you could then rebalance to restore your target allocations, applying the gains to your cash and international stock allocations. 

Retirement Income: The Total Return Approach

Note that the fixed income return, at 6%, may seem high—but in this example, about half of that is income and half is price appreciation. In other words, it really is a stretch to depend solely on dividends and interest—which brings us to our next point.

The risks of a yield-only strategy

In today’s climate, a yield-only strategy may give you a feeling of security that could end up masking potential problems, Rob warns. 

  • You’ll stretch for yield. You may be tempted to shift into riskier investments such as high-yield bonds, master limited partnerships (MLPs), real estate investment trusts (REITs) or other higher-yield investments. Though these can be appropriate in the right circumstances, our research shows that certain higher-yield investments can introduce equity-like risk, especially in a rising rate environment, heightening your portfolio’s swings in value. (In other words, you could jeopardize the very principal you were afraid to touch.) 
  • You’ll fail to diversify. Nearly every portfolio should have a mix of growth and income investments. The growth piece offers the potential for the principal to appreciate faster than inflation. The income piece, of course, provides money to live on. Trying to eke out a reasonable living from dividends and bond income may necessitate dedicating a disproportionate share of your portfolio to fixed income, making the overall mix less diversified and—paradoxically, since bonds are often viewed as safe, conservative investments—more risky because it may not keep pace with inflation.
  • You’ll live well below your desired lifestyle. Our hypothetical investor with the million-dollar portfolio was able to generate a $50,000 retirement “paycheck” through a combination of dividends, interest and asset sales. If they just relied on dividends and interest, they would have generated a little over $23,400. That could translate to a very different retirement lifestyle.

Tapping multiple sources of income

Even if you feel that the potential risks listed above don’t apply to you, that’s not a reason to disregard the benefits of a distribution strategy that taps multiple return sources, including the strategic sale of some assets, which could provide the income you need. 

If rebalancing alone doesn’t come up with the amount of cash required, consider making an appointment with a Schwab Financial Consultant who can help identify the best strategy for selling other assets that takes both market potential and taxes into consideration.


Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

In the hypothetical portfolio shown in this article, the indexes representing each asset class are: Citigroup 3-Month U.S. Treasury Bills (cash equivalents); Barclays U.S. Aggregate Bond Index (fixed income); S&P 500® Index (large-cap equities); Russell 2000® Index (small-cap equities); MSCI EAFE® Net of Taxes (international equities).

Citigroup 3-Month U.S. Treasury Bill Index is an index that measures monthly total return equivalents of yield averages that are not marked to market. The 3-Month Treasury Bill Index consists of the last three three-month Treasury bill issues.

Barclays U.S. Aggregate Bond Index includes fixed-rate debt issues rated investment grade or higher by Moody’s Investors Service, Standard & Poor’s®, or Fitch Investor’s Service, in that order. (It also includes commercial mortgage-backed securities.) Bonds or securities included must be fixed rate, must be dollar denominated and non-convertible, and must be publicly issued. Bonds included span the maturity horizon, although all issues must have at least one year to maturity. All returns are market-value weighted inclusive of accrued interest.

The S&P 500® Index is a market-capitalization weighted index that consists of 500 widely traded stocks chosen for market size, liquidity and industry group representation.

Russell 2000® Index is a market-capitalization weighted index composed of the 2,000 smallest companies in the Russell 3000.

Russell Indexes are subsets of the Russell 3000® Index, which contains the largest 3,000 companies incorporated in the United States and represents approximately 98% of the investable U.S. equity markets.

MSCI EAFE® Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure developed market equity performance, excluding the U.S. and Canada. The MSCI EAFE Index consists of the following 22 country indices: Australia, Austria, Belgium, Denmark, France, Finland, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom.

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