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A Total-Return Approach for Retirement Income

When thinking about income in retirement, many investors embrace the adage “never tap growth or touch the original investment.” However, generating an acceptable income solely from interest and dividends requires a sizeable portfolio, and isn’t practical, realistic or necessary for many investors.

Instead, you might consider a multiple-source approach in which you rely on predictable income streams (like annuity or Social Security payments), collect regular interest and dividends—and generate income by selling assets, if the first two sources aren’t enough. It may sound contrary to standard wisdom, but a total-return approach can mitigate some of the risks of a wholly income-oriented portfolio, provide more flexibility and can help create sustainable growth for a longer retirement.

What does “total return” mean?

The total return from a portfolio includes price growth plus interest and dividend income. Incorporating both yield and price appreciation can help smooth and increase your income stream, despite inevitable fluctuations in the market. A total-return approach to investing and income generation is about using your whole portfolio to generate returns from a range of sources, including interest, dividends and growth.

Most institutional investors—university endowments and pension plans—are now following a total-return strategy to meet their funding needs, making their portfolios less susceptible to the fluctuations of the market. You can do the same. Here’s how to put a total-return strategy into practice.

The building blocks

Here are three strategiesor stepsyou can use to generate income from an investment portfolio:

  • Interest and dividends only: In this approach, you rely on investment income only, without touching growth or the original investment.
  • Total-return approach: This strategy aims to generate a targeted annual return from all sources (interest, dividends and growth), and may or may not involve touching the original investment. It could make sense to think of this as interest and dividends “first.” If interest and dividends alone are enough to support you, greatif not, you can tap growth and/or the original investment (consider using a rebalancing approach, as described below).
  • Total-return approach combined with other insured/guaranteed sources: In this approach, you use predictable sources of income (such as Social Security, a pension or annuities) to cover essential expenses. Remaining assets are invested in a diversified portfolio to generate interest, dividends and growth. This approach may or may not involve selling or tapping your original investment.

 

Building blocks of income to fund retirement

Source: Schwab Center for Financial Research. Guaranteed income can include income from Social Security, a pension, or annuities. Annuity guarantees are subject to the financial strength and claims-paying ability of the issuing insurance company.

 

Think of each less as a different approach and more as a building block. Most portfolios generate some interest and dividends. The bigger question is, “Is that income enough to live on?” Instead of an interest-and-dividends-only strategy, think of it as a strategy that uses interest and dividends first, before moving on to other sources of income if that’s not enough.

For example, a portfolio with $500,000 might generate $12,500 to $15,000 per year in investment income from relatively conservative investments (based on an average 2.5% to 3% yield). If that’s not enough, you would tap investment growth. If more is needed, you would move on to selling some of the principal (i.e., the original investment).

Start with a strong foundation  

If you’re like most retirees, remember that your portfolio won’t work alone. Social Security payments, a pension or an annuity can serve as the foundation on which to build a solid retirement income plan. These income sources are often less exposed—or not exposed at all—to market risk.

For example, let’s say you hope to spend $100,000 annually in retirement, and your Social Security payments and an annuity will generate $50,000 every year. That means you’ll need your investment portfolio to generate the other $50,000.

How can you do that? Here’s an example: Let’s say you’re retiring with a $1 million portfolio, and you need $50,000 from it each year to supplement your Social Security and annuity income. In the hypothetical example below we’ve assumed a moderate asset allocation, with $50,000 in cash to start.

A sample spending plan

Note: Interest and dividend payments are deposited to cash. Total return includes price growth plus dividend and interest income. The example is hypothetical and provided for illustrative purposes only. It is not intended to represent a specific investment product. The example does not reflect the effects of taxes or fees. The indexes representing each asset class are: cash = Citigroup 3-Month U.S. Treasury Bill Index; fixed income = Barclays U.S. Aggregate Bond Index; large-cap equities = S&P 500® Index; small-cap equities = Russell 2000® Index; international equities = MSCI EAFE® Index. Please see the disclosures section at the end of the article for descriptions of each index. 

Source: Schwab Center for Financial Research with data provided by Morningstar Inc.

 

Throughout the year, investment income was collected as cash. In the hypothetical example below, you withdraw the $50,000 cash you need for the year and rebalance your portfolio, selling and purchasing assets as needed to restore it to its original target allocations.

How to restore your target asset allocation by rebalancing

In the hypothetical portfolio above, the indexes representing each asset class are: cash = Citigroup 3-Month U.S. Treasury Bill Index; fixed income = Barclays U.S. Aggregate Bond Index; large-cap equities = S&P 500® Index; small-cap equities = Russell 2000® Index; international equities = MSCI EAFE® Index. Please see the disclosures section at the end of the article for descriptions of each index. The example does not reflect the effects of taxes or fees. 

Source: Schwab Center for Financial Research with data provided by Morningstar Inc.

 

The risks of a yield-only strategy

A yield-only strategy may give you a feeling of security that could end up masking potential problems in today’s climate:

  • You may 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 historically higher-yielding investments. Though these can be appropriate in the right circumstances, our research shows that certain higher-yield investments can introduce equity-like risk, heightening your portfolio’s swings in value. In other words, you could jeopardize the very principal you were afraid to touch.
  • You may 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 may 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 he or she just relied on dividends and interest, the portfolio would have generated a little over $23,400. That could translate to a very different retirement lifestyle.

 

Getting started

The first step is to choose the right mix of investments to provide properly diversified sources of return. 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 and rebalancing.

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 you identify the best strategy for selling other assets that takes both market potential and taxes into consideration.

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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.

All annuity guarantees are subject to the financial health and claims-paying ability of the issuing insurance company. Neither Schwab nor its affiliates provides insurance guarantees.

The information presented does not consider your particular investment objectives or financial situation and does not make personalized recommendations.

Diversification and rebalancing a portfolio cannot assure a profit or protect against a loss in any given market environment. Rebalancing may cause investors to incur transaction costs and, when rebalancing a non-retirement account, taxable events may be created that may affect your tax liability.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk.

Performance may be affected by risks associated with non-diversification, including investments in specific countries or sectors. Additional risks may also include, but are not limited to, investments in foreign securities, especially emerging markets, real estate investment trusts (REITs), fixed income and small capitalization securities. Each individual investor should consider these risks carefully before investing in a particular security or strategy.

Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly.

The 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.

The Bloomberg 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.

The 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.

The 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.

Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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