The 4 Pillars of Cash Flow in Retirement

Michael Kitces is a partner and the director of wealth management for Pinnacle Advisory Group, co-founder of the XY Planning Network, and publisher of the continuing education blog for financial planners, Nerd's Eye View. You can follow him on Twitter at @MichaelKitces.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. What are the key sources of retirees' portfolio cash flows and how might they change over time? Joining me to discuss that topic is Michael Kitces. He is a financial planning expert.

Michael, thank you so much for being here.

Michael Kitces: Thanks, Christine. Good to be here today.

Benz: Michael, you had a terrific piece on your website where you've looked at the sources of cash flow that retirees can extract from their portfolios, and I'm hoping we can take them one-by-one. These will be familiar to all of our viewers. But I'd like to start by talking about what they are and also how they've evolved in importance for investors over time.

Kitces: Sure. So, as I view it, ultimately there are kind of four core pillars about where we generate cash flows from a portfolio. And an important note to this: I very deliberately call them cash flows and not income …

Benz: I love that, by the way.

Kitces: … because the reality is, particularly in our tax world, not every dollar that you take out of your portfolio has the same tax treatment. In fact, not all of it has tax consequences at all. And I find we create a lot of confusion for ourselves sometimes by getting anchored on what's called income--by someone's definition of income, recognizing that investment folks call different things as income than even what the tax code does. So, I'd like to talk about this in terms of cash flows.

So, we find cash flows ultimately come from four sources. Number one is interest. So, good old bond interest going all the way back to the days where people generated their retirement income by buying bonds and literally clipping the coupons. Those who don't know, like the early days of bonds, like you got a physical bond, your bond interest coupons were a little piece of paper attached, you literally cut them with scissors and send them in to get your bond interest.

Benz: My grandparents did just that.

Kitces: So, there was clipping the coupons of the bond interest. That worked well for a while. Then inflation showed up and people realized like, OK, well, bonds have some trouble when inflation is high. So, we started migrating, and we started getting dividends from stocks instead and we saw a big rise of dividend-paying stocks, particularly in the late '70s, into the '80s realizing that bond interest is fixed, stock dividends can rise, it can keep pace with inflation because the prices rise with inflation, earnings rise with inflation, so the dividends tend to rise with inflation. So, we saw dividends kind of become the second pillar of portfolios.

Then as we went further into the '80s and '90s and had that amazing bull market, investors started saying, OK, well, I've been getting my bond interest, I've been getting my dividends, and it's going great except saying, I didn’t notice the portfolio is like twice as valuable than it used to be because of the bull market? So, we started recognizing the capital gains are really a third pillar of portfolio cash flows.

Then we ultimately have the fourth pillar, which is, the account balance itself, the principal. Obviously, when we're looking at retirement planning, I don't want to spend the principal too fast and run out, but at the same time, what I find--certainly, there are exceptions--but for most people that we work within our advisory firm, we'd say, what are your goals for this money, it's something to the effect of--I want to spend my money in my retirement, and not like I want to just spend the growth portion and leave like a giant pile over to my kids. Some people have that goal. But for the most part, I want to enjoy my money and enjoy my money means enjoying all of my money, the growth and upside and the actual amount that I saved, which means at some point we have to mix in principal as well, not so quickly that we run out, but not necessarily so slowly that we never enjoy the money.

And so, by the time we mix those together with very different tax treatments, we end up with interests, dividends, capital gains, and the principal itself and those become the four pillars that can use to draw our cash flows from a portfolio in retirement.

Benz: OK. So, from a practical standpoint, my sense is that a lot of retirees come in to retirement some preconceived notion about this source of cash flow from my portfolio is good, this one bad. So, a common one is, interest income, dividend income--all good, I'm comfortable with that; I never want to touch my principal. Or I talk to some retirees like that. So, let's talk about kind of the disadvantages of being overly anchored on a single source of cash flow for your retirement cash flows.

Kitces: Yeah. I mean, I literally kind of draw this as four pillars, so you imagine like a big roof and four Greek pillars. The more pillars you've got supporting the roof, the more stable it is. And I think certainly that really is true when it comes to the retirement cash flow pillars. And literally, in terms of how they have evolved, most of them evolved in popularity because people depended on one of the pillars and then the pillar got undermined and we said like, oh, should we need a new pillar? So, like, bond interest is great, and then inflation showed up. Dividends were great, and then we said, oh, my God, I'm leaving all these capital gains on the table. Capital gains are great except as we certainly know you don't get those every year. So, we can't solely rely on those.

And while I recognize--I mean, certainly we see it with our clients as well--I mean, no one wants to dip in their principal too early and run out. But at the same time, there are some points where you're 90-something years old and we're getting on later years, you'd to say, you know what, it might be OK if we touch a little bit principal; we're probably not going to work through it at this point. And so, it's not to say hey, you got to tap your principal in the second year of retirement because that's probably going to be depleting too early. But recognizing that at some point we should recognize this is an asset on the table is important, especially, when we get in the times of, say, market volatility and we say, well, where am I supposed to get my money? Because my portfolio is down, I have no capital gains, and my interest and dividends aren't making it up, the answer is, well, maybe that's a time that's OK to touch a little of, we'll call it, "principal" while you leave some stocks that are invested with an opportunity for a rebound, you leave some bonds that are invested with the opportunity for rates to rise.

And so, the whole point is, when you've got four different pillars to rely on, particularly from year to year, you can use whichever one is available and appealing cooperating with you that year and not need to push too hard on a pillar that doesn't have the strength that year.

Benz: OK. The big question is, how do retirees, kind of, identify where to go for cash flow on a year-to-year basis? What are some things--obviously, they want to think about the investment piece and where it makes sense to draw from. But as you mentioned, this gets a little more complicated if people have multiple silos of assets with different tax treatments. Do you have any best practices to share on how people can make good decisions on this front?

Kitces: Yeah, a couple of best practices that I would share. Number one actually is just--I'm not kidding when I say separate out what is income, especially for tax purposes, from what are the cash flows you're generating for your retirement spending. So, there are lots of ways that might generate cash flow that isn't necessarily income for tax purposes. That might mean I deliberately draw my brokerage account, and I leave my IRA because I could have interest in both but one of them is more taxable than the other. Or one is a qualified dividend but the other is an IRA distribution which is taxed differently, or one is an MLP distribution that might not be taxable, but I could take cash principal out of my IRA--and that's fully taxable because it's an IRA distribution. So, separate out what you are doing for investment purposes for tax purposes, because they really function separately.

For investment purposes, more often we see people get on a strategy that's fairly straightforward, something in the effect of I'm going to take some of the interest and dividends that are being generated, I'm going to supplement it with capital gains if the markets are up. If the markets are down, I'm going to use cash and let the portfolio recover and to me essentially using cash is a way of--it's dipping in your principal because it's certainly not an interest or a dividend or a capital gain. So, draw on the income cash flows that are there, use capital gains if we're up, tap cash if we're down, and use a little bit of that principal to leave the stocks invested.

Now, when we look at this from a tax perspective, our optimal tax strategy looks different. Optimal tax strategy is more along the lines of: let our tax-preference accounts grow, tap our taxable brokerage accounts first. Now, we don't want to just let the pre-tax IRA grow indefinitely or eventually we have required minimum distributions that drives upper tax bracket. So, we often look at strategies like, for cash flow purposes interest and dividends, capital gains if we're up, cash if we're down. For tax purposes, draw as much money as I can from the brokerage account and with my IRA do partial Roth conversions, move the money from an IRA over to a Roth IRA, fill up a low tax bracket to do it at a fairly efficient tax treatment, and now my tax consequences are completely separate from my retirement cash flow strategy. That's actually part of the point because what is best for cash flow is not necessarily best for tax purposes and what's best for tax purposes is not necessarily best for cash flow. So, we really have to look at both separately to figure out what's best when you bring them back together.

Benz: OK. Obviously, a lot of moving parts here. But it's an important topic and I think one that's under-discussed. Thank you so much for being here to talk about it.

Kitces: My pleasure. Thank you.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.