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Generating Income in a Low-Yield World

Christine Benz

Christine Benz: Hi, I'm Christine Benz for

Retired investors face the challenge of trying to earn a livable income in a very low-yield environment. Joining me to discuss that topic is Fran Kinniry, a principal in Vanguard's Investment Strategy Group.

Fran, thank you so much for being here.

Fran Kinniry: Thank you, Christine.

Benz: Fran, one thing that we both see in our work is that investors do very much look for income from their investments. They want to be able to spend that yield and not have to invade their principal in any way. What are the risks of focusing strictly on current income when you are building your portfolio?

Kinniry: Right now, the taxable bond market has a yield of around 2%, and the dividends on stocks are around 1.8%. Normally the recommended spending is 3% or 4%. There is a gap.

So investors have tried to engineer a higher yield. They are overbuying dividend stocks--they'll buy stocks that have 3%-4% yield--or they'll go up the credit spectrum in fixed income toward corporates or high-yield corporates or emerging-market debt. The risk to that is, a) you're becoming less diversified, and b) you are concentrating your assets in a certain style and also your bonds now look closer to equities. So if we do run into any patch of trouble, you are going to be unlikely to be able to preserve your assets because all of your assets have some equity link to them.

Benz: Investors who are income-centric often hear, you should be total return-oriented. What does that mean in practice?

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Kinniry: Total return in practice means don't try to re-engineer the yield. Keep your portfolio broadly diversified. Don't overweight dividend stocks. Don't overweight credit or high yield.

Benz: You don't have to avoid them altogether; they very much can be part of your plan.

Kinniry: Exactly. But now if you need 4%, and your portfolio is only giving you 2%, you then have to sell some assets to generate that other 2%.

Let's just take an easy number--a $100,000 portfolio. [At a 2% yield,] your portfolio is generating $2,000; you would also have to sell $2,000 to get to$4,000. How would you do that? Hopefully you will be selling assets in your taxable account that have the lowest gain in them and then rebalancing your tax-qualified plan. Hopefully more times than not, the stock market is providing a return; the average return in the stock market is 9%. So, you are not really dipping into principal; you are spending what the equity market has provided you in, let's say, three out of four years.

Benz: How about, though, in a year when the equity market isn't doing anything or you've got losses in the equity piece of your portfolio. Your income producers only take you so far, as you said. What do you do then?

Kinniry: You are still selling the principal. The stock market has dropped one out of every four years. If your equities are down, you are selling, but you're still rebalancing, so you're not distorting your asset allocation. It doesn't really matter whether stocks are down or up. You're selling to get the income you need and then rebalancing so your asset allocation is still the same.

Benz: We've got a lot of users on our website who like the bucket strategy for putting together their retirement portfolios. They've got a cash bucket that they use, and that is maybe going to cover them for, say, a year's worth of living expenses. And they are, in your view, putting the income distributions and capital gains distributions directly into bucket one as they occur, and then perhaps using rebalancing proceeds to help them hit their income target?

Kinniry: That's exactly right. Let's move from a $100,000 to a $1 million [portfolio]. If you were to start off with 12 months of income in your cash bucket, that's $40,000 if you wanted to spend 4%. So you put the $40,000 in a money market then the rest of the portfolio is allocated in a total return [manner], meaning you're not overweighting dividend stocks. And then what you'll do is, you'll have to replenish that $40,000. The first part of that would be all of your flows from your bond funds would go into your money market. All of your flows from your equities will go into that money market. And at the end of the year, you would then have to sell some portion of your total return to replenish the rest. As I said, sometimes it may be that you are cutting into real principal if the stock market is down, but three out of four years, you're going to actually be taking some of the gains off the table from the equity return.

Benz: Would you ever be selling a portion of your bond holdings, if bonds had a very good run and your bond position was larger than you intended it to be?

Kinniry: What you're really trying to do is to be tax efficient. So, you're going to sell whatever is the most tax efficient--stocks, bonds or cash--but then you are rebalancing. So, it doesn't really matter what asset you are selling, because you're going to return the portfolio [to its target allocation]. Let's say your asset allocation was 60/40, and stocks dropped in 2008; you would be selling bonds. But in most years, you're going to be selling equities and then rebalancing inside.

Benz: Fran, thank you so much for being here to discuss the logistics of the total return approach.

Kinniry: Thanks, Christine.

Benz: Thanks for watching. I'm Christian Benz for