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.
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.
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.
What you can do next
The concept behind total return investing is simple, but—as our example shows—actually generating a “paycheck” through rebalancing can be a little bit more involved. Find a Schwab Financial Consultant near you who can help you plan and implement a total return strategy.