Income or Total Return? Retired Users Weigh In

Are you an incomenik or a totalnik? Or a combination of the two?

The community of retired investors on Morningstar.com has long seemed to break down into these two factions: those who look to their portfolios to crank out current income (the incomeniks), and investors who favor a total return approach (the totalniks).

In an effort to hear both viewpoints as well as gather practical strategies for managing a nest egg during retirement, I ventured on to Morningstar's Discuss boards and posed the following question on the Investing During Retirement forum: "When managing your portfolio during retirement, do you take an income-focused approach, or do you use a total-return strategy that involves tapping your principal? Or a combination of the two?" A lively thread ensued.

Battle lines were drawn from the start, but many posters were nuanced in their responses, noting that a blend of the two approaches may be the best answer for most investors. I've encapsulated many of the posts below, but I urge you to read the full thread because posters also included many valuable links to related readings. Many posters also included specifics about how they were positioning their portfolio. There were more many more worthwhile posts than I could showcase here, and more were rolling in as a put this article together; check the thread to see the latest.

For the Totalnik Side
Frequent poster Avilynn kicked it off with a vote for total return, pointing out that the more favorable tax treatment that capital gains currently receive (versus a higher rate for current income from bonds) is a key reason: "Being a retiree since 1969, and sitting only on taxable accounts, I wouldn't dare making a living on interest and dividends, but only on capital gains. And now with the chance of terminating the lower tax on qualified dividends and cap gains, it's even more so. Ordinary interest and dividends are 'poisonous' to my health."

Ker5ry also weighed in on the total return side, sharing an approach that combines safe investments for near-term income needs with a growth portfolio: "I think for the long term focusing on total return is safer. I have three years of annual expenses in money market and short-term bond funds and the rest in equities without much concern for the high-dividend-paying stocks."

Erryl, too, noted that focusing on yield alone can carry pitfalls. "I am surprised how often I hear people caught up in the yield parameter because, to me, total return is the easy answer to your question. Today, it is easy to sell securities with minimal fees to get income whenever you need it. Most of us dollar-cost averaged into our portfolios ... There is nothing wrong with liquidating it the same way. Besides, yield that doesn't also have a good total return is not sustainable. Look how many people rode their REIT closed-end funds into the dirt in 2008. They held as long as their dividend was not reduced right up to the point where they had severe dividend cuts and much of their principal was gone. Their premise that they could sell if the dividend was cut was not realistic because at that point the net asset value was decimated."

All Income, All the Time
Yet as convinced many totalniks are in their approaches, some other posters were just as certain that an income focus is the way to go. For example, Conair wrote: "I believe in income investing for all investors. Cash income is real. Magic wands and buy and hope is not. Quite simply, will your mutual funds be higher at your retirement age? Is  Google (GOOG) going higher or lower? No one knows for sure.

"But we do know that asset allocation works. Diversification works. Dividend-paying stocks work. Isn't it better to make 5% annually from  Dodge and Cox Income  (DODIX) than lose 50% of your net worth during a bear market? Vanguard's  Wellesley Income (VWINX) fund has averaged nearly 10% annually with only a 35% exposure to equities. Dividend-paying equities. Do it yourself or do it with help, but do it with real-income investments. You worked hard for your investment assets, you deserve a real-income return."

ElLobo is similarly income-oriented, though this poster's view of what constitutes income might be more expansive than is the case for other posters: "I have been retired for seven years now and am focused exclusively on the yield thrown off by my portfolio. Specifically, the amount I withdraw from my portfolio, in percentage terms, is less then the overall weighted percentage yield of my portfolio. Stated another way, if my portfolio yields $X, I withdraw and spend no more than $X. That means I never have to sell shares of any portfolio asset to cover a withdrawal. Furthermore, if I need to withdraw more than $X, I adjust my portfolio holdings to generate more yield income.

"For the most part, yield means bond interest and stock dividends. But it also means, in my case, fund distributions, which may include capital gains or returned capital. It also means, in my case, other sources, for example, covered-call writing proceeds, which are not dividends or interest."

Combining the Two
Scott43, like many other posters, split the difference. He argued that a total return focus makes sense earlier in one's investing career, and an income approach is the way to go later on. "I've been retired for four years. The year I retired I switched from total return to income oriented. Total return is really the only choice one has during the accumulation phase: It's how you get to the magic number.

"But then things change. In retirement I no longer have a need to focus on portfolio growth; I just need it to counteract inflation during 20-30 years. I cannot depend on the market to give me a good price when I need to sell something for income. The market is too volatile for that. I don't want to be forced to make market-timing decisions on what and when to sell ... To my mind, dividends and interest solve a lot of problems for retirees. I do not sell anything for income."

Molokoeo also espouses an approach that melds income with total return. "The income portion of my portfolio (65%) is buy and hold. Its sole purpose is cash flow--bond funds and exchange-traded funds, REITs, master limited partnerships, preferreds, utilities, and an income-builder fund reside here. Nothing gets sold for appreciation; only if I find a better candidate (driven largely by yield) or conditions in the macro investing climate change do I sell one of these positions."

"The growth part of my portfolio (25%) is managed with an eye for capital gains. Individual stocks and ETFs live here and are bought and sold when price targets are met. The smallest part of my portfolio (5%) is hedges--gold, silver, and an inverse equity ETF. These positions ebb and flow as macro conditions dictate and are meant to smooth out the ride in the event of a nasty downdraft. The final 5% of my allocation is cash, which I draw down for living expenses. Sure would be nice one day if it also contributed some income, too!

"I'm retired and invest solely in my IRA, so taxes play no role in determining whether to favor dividends or capital gains. I take only as much risk as is prudent to generate the money I need to live on--primarily dividends and interest, and secondarily, capital gains."

Billperk concedes the attractions of a yield-focused approach, but goes on to note that being able to live off a portfolio's income is the domain of wealthier and/or very frugal retirees. That, in turn, leads him to favor a blended approach for most investors: "I believe most folks would prefer to live off bond and dividend yield if they can reconcile that with their desired asset allocation and asset level. It seems to me living off income alone requires a higher ratio of assets to expenses, perhaps 40 to 50 times, and/or a lower withdrawal rate. Someone with a need for say a 2.5% withdrawal rate can easily set up a diversified portfolio that will provide that income without stretching for yield.

"Reality is, many folks don't have sufficient assets to live off yield alone and therefore would be risking their retirement by allowing mainly very high-yield vehicles to dominate their portfolios. I believe those folks are better off using the combination of yield and total return strategy."

Rpetrocelli, while not yet retired, favors a total return strategy, but also keeps a sleeve of his portfolio in dividend payers. "A portion of my portfolio consists of 20 individual stocks. All of those stocks pay at least a 2% dividend. My goal is to increase the dividend amount each year. When I retire, I will use the dividends paid to supplement my income."

TaylorZR wrote in favor of a hybrid approach, noting that products designed to ease the transition from accumulation to decumulation would be welcome: "The correct answer is both, as parts of a total portfolio designed for long-term income growth, where capital gains are reinvested instead of consumed, and the income per share increases over time ... A real myth for retirement is using a standard balanced mutual fund portfolio more dependent on capital growth than income growth, where mutual fund shares are sold off for consumption, and income growth per share is not a part of the main goal of the portfolio.

"The mutual fund industry has failed to create the proper transition products for investors to go from accumulation to decumulation."

Glebb shared this common-sense withdrawal strategy for meeting income needs: "With a good pension and favorable tax situation, we had very wide latitude to decide on our withdrawal formula and organize our portfolio to match. We have no tax-deferred accounts.

"We chose to withdraw 5% of each year's ending balance, with no inflation adjustment; we would take 4% in bad years and could take no withdrawals in a long bear, if needed.

"So, we've set up the portfolio with 35% equities/65% bonds, and the yield is above 4%; all distributions go into our money market accounts, and we keep one year's withdrawal (5%) in a short-term bond fund. With capital gains, we should be able to maintain our 5% withdrawals, without touching principal, and normal/good years should allow us enough cash to rebalance. The way we're set up, we shouldn't have to sell anything, but if we had a very long bad run, we'd have no problem selling.

"I would call our plan an income-focused approach with a total return backup."

ColonelDan, too, favors a retirement strategy that combines total return with some income-producing vehicles. "I use a modified total return approach with a three-bucket income orientation.

"1. Cash accounts: Checking for monthly expenses fed by military pension, social security, and miscellaneous income on a monthly basis. This more than covers my normal expenses and routine discretionary spending since I have no debt of any kind.

"2. Income accounts: These are taxable accounts but I've placed tax-free intermediate-term bonds, short-term bonds and a money market fund here. The dividends from the two bond funds are fed directly into the money market account which is used to feed the cash account if and when needed to augment the pensions or for unique larger purchases--a car or home improvement projects and so on If not needed, the money is reinvested.

"3. Growth accounts: Tax advantaged accounts (such as IRAs), stock, and taxable bond funds with a long-term growth and inflation-hedge objective. If the dividends generated by the income account becomes insufficient, My plan is to transfer money from the growth accounts into the income accounts to increase the dividends to offset inflation. If needed for a large immediate expenditure it will go directly into my dash account. So far, I have not had to use any funds from bucket 3. I've been able to let it grow with all dividends and capital gains reinvested.

"This system has worked for me so far, and I've been able to keep my withdraw rate at a skinny 1%."

See More Articles by Christine Benz

Become a Morningstar Content Contributor Today! Contributing content to Morningstar allows you to increase your firm's exposure to a premium audience of financial advisors and individual investors. Please click here to learn more about the Morningstar Content Submission Platform. For additional guidance in using the Content Submission Platform, please view this video.
		New! 30-Minute Money Solutions
	Need help picking up the pieces in this turbulent market? 30-Minute Money Solutions by Morningstar director of personal finance Christine Benz simplifies the daunting task of getting your financial house in order. Written for novice and experienced investors alike, this book offers manageable, step-by-step solutions for tackling money challenges and building a comprehensive financial plan in simple 30-minute increments. Learn more.
	Order Your Copy Today--$16.95