Generating Income: Part Four of Our Special Five-Part Series
During their working years, investors focus on saving and investing with a goal of building wealth. As they enter retirement, either by ceasing paid employment entirely or by scaling back paid employment, investors shift their focus to using their portfolios to provide a reliable long-term stream of income. This transition from building wealth to income generation is the subject of a great deal of research in retirement planning. Once investors are at or near retirement, the most significant financial challenge is using their accumulated savings to provide substantial income for their retirement years.
The four common ways to convert a portfolio to an income stream are:
An investor may choose one of these approaches or combine them. The following sections provide overviews of these four strategies.
With systematic withdrawal, you have a target level of income that you will draw from the portfolio. You will use dividends and bond coupon payments as part of the income and sell assets in your portfolio, as needed, to reach your target income. Because you may be selling some portion of your assets every year, the portfolio may eventually be entirely depleted. The larger the income draw, the higher the probability of using up your savings before you die.
Investors who plan to use a systematic withdrawal approach to providing income in retirement tend to focus on a total return approach to their portfolios. They do not care whether they get their income from dividends, coupon payments, or from selling some portion of their assets. I believe that it is reasonable to say that a total-return systematic withdrawal approach is the most common standard practice in retirement income planning. This is the approach that Vanguard advocates, for example. This is also the approach that many Target Date funds and strategies use.
There is substantial literature that examines how much income an investor can draw from a diversified total-return-focused portfolio with a high degree of confidence that he or she will not run out of money. This line of research is often referred to as the study of safe withdrawal rates (SWRs). Studies of SWR start with a specific size of portfolio at retirement and then attempt to determine a constant inflation-adjusted annual income that can be drawn from that portfolio with a high probability of lasting through retirement. The standard rule-of-thumb is that investors can draw 4% of the value of their portfolios at retirement and increase this to keep pace with inflation (this is often referred to as the 4% rule). There are many assumptions that go into determining a SWR and these studies are closely related to the types of wealth accumulation analysis authored by Ibbotson and Fidelity cited earlier. The 4% rule means than an investor retiring with a $1 Million portfolio can afford to draw $40,000 in income the first year and then escalate that each year to keep pace with inflation. The specific choice of portfolio can vary somewhat, but typically looks something like 60% stocks and 40% bonds. Some studies use long historical data records and see how well a given spending rule holds up, while others use simulations that assume expected future returns and risks for different asset classes. Over the past 50+ years, a 4% income draw has been quite safe but the real question is whether the future will be similar to the past.
With income investing, you design a portfolio primarily to generate the maximum income via dividends, bond coupons, and distributions from REITs and other income-generating assets such as MLPs. You will consume the income generated by the portfolio, but no more. The income may drop below the expected level if a stock has its dividend cut or a bond issuer defaults.
I have written quite extensively about income investing in recent years. From the perspective of financial theory, there is no reason to believe that income investing is superior to total return investing. On the other hand, there is no reason to believe that income investing is less viable than total return investing. Perhaps the greatest hurdle for a pure income approach is that such portfolios may look quite unconventional and thus raise issues about ‘suitability.’ The providers and sponsors of 401(k) plans and other self-directed retirement plans must choose strategies that are conventionally accepted as prudent and reasonable and my research into pure income-focused portfolios often yields asset allocations such as high-yield bonds (aka junk bonds) and Master Limited Partnerships (MLPs), for example, which are unfamiliar to many investors.
An annuity is an insurance product. The investor pays a specific sum of money to the insurer in return for a stream of future income that will continue as long as the investor lives. There are many types of annuity contracts and a full discussion is beyond the scope of this article. The simplest form of annuity is an immediate annuity, in which the insurer (the seller) receives a one-time payment and provides a specified income (a specific number of dollars per month from purchase until death) to the purchaser for the rest of his or her life. This is called a single-premium immediate annuity (SPIA). The primary risk with SPIAs is inflation risk, although some insurers do sell inflation-indexed SPIAs. Investors looking at SPAIs should be certain about whether the annuity they are purchasing will produce an income stream that will keep up with inflation or not. The key attraction of annuities is that the income stream that they provide will not run out during your lifetime—so-called longevity risk is no longer a problem. The primary downside of annuities is that the purchaser signs away his or her savings in a lump sum and that decision is irreversible. One additional risk factor of annuities is what happens if the insurer defaults. While rare, this can occur.
The safest approach to generating retirement income is to purchase inflation-protected government bonds (TIPS) with maturities that will provide a specific amount of inflation-adjusted income through retirement. This approach, introduced and championed by Zvi Bodie, is worth understanding. A bond ladder is a portfolio of bonds with maturities at successive dates into the future. With Bodie’s approach, you purchase TIPS that will mature as you need the principal invested in the bonds. The inflation-protection ensures that the purchasing power of your money will at least keep up with inflation. The challenge with this approach in the current environment is that the real (after inflation) yield on TIPS is zero. If you need $10,000 in purchasing power in ten years, you would need to purchase $10,000 of ten-year TIPS today. You will not receive any investment gain beyond the rate of inflation. The TIPS ladder approach has always been a low-return strategy as compared to alternatives but, as Bodie has attempted to explain to investors for many years, higher-return assets carry more risk than most investors realize. The adage that stocks become less risky the longer you hold them is a dangerous misconception.
In practice, a combination of these income strategies (total-return systematic withdrawal, income investing, annuities, and TIPS ladders) may be the most attractive, depending on an individual’s specific needs and situation. It is worth understanding the advantages and limitations to each of these four basic approaches to generating retirement income.
Each investor’s life cycle transition from saving and building wealth to generating sustainable income is a crucial one in life cycle planning. As America goes through its demographic shift to a population with a large portion of the population in retirement or approaching retirement, we can anticipate that there will be increasing focus on this challenging problem. The choices among the available alternatives will reflect the degree to which investors assess the seriousness of different types of risk and their willingness and ability to reduce their current standard of living to reduce these risks. The choices between these different approaches also must reflect specific individual circumstances.
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