Why Not Dipping Into Principal Can Be Dangerous

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Many retirees wrestle with how to extract cash flow from their portfolios. Joining me to share his perspective on the behavioral aspect of retirement planning is Meir Statman. He is a professor of finance at Santa Clara University.

Meir, thank you so much for being here.

Meir Statman: Delighted to be with you, Christine.

Benz: One of things that jumped out at me in your book, "Finance for Normal People," you had a piece about what you call the dividend puzzle. This is something I definitely encounter when I talk to retirees. They don't mind subsisting on the income from their portfolios, but they consider the principal absolutely sacrosanct. They never want to touch it. So, let's talk about this. You call it a little bit of a puzzle. Let's talk about why it is a puzzle that people approach their portfolios in this way.

Statman: Well, it is a puzzle in standard finance. And the reason is that actually it is better for you to take money out of your portfolio in the form of capital and capital gains than dividends because this way you actually pay lower taxes and you can get the money when you want rather than when a company sends a dividend check. And so, the question really is, why is it that people have such a preference for cash dividends. And behavioral finance answers the question.

And what we say is that people need rules for self-control. The problem that people face is the problem of how to invest, how to save during their working years, and then how to spend, but not too fast, in retirement. And so, the rule that has come to be accepted by people is the mental accounting rule. You frame money as income or capital, and you add a rule that says spend income, including dividends, but don't dip into capital. And that is a wonderful rule for your working years when you save and you're not tempted to dip into capital to buy some fancy car or whatever it is.

Well, the problem is that once people retire and they are actually spending from their portfolio rather than saving, that rule gets in their way because they want to get income and since interest rates are low, well, they buy junk bonds and get themselves into risks that they might not understand. They buy high-dividend stocks and they concentrate their portfolios in banking and utilities. Some of them even buy those funds that kind of get extra dividends, dividend capture funds …

Benz: Terrible products.

Statman: … that are terrible products, precisely, for that reason. And so, what we need to do if we are going to help people is help them by finding ways to regulate consumption but not restrict it to levels where they live like misers even though they have very ample portfolios.

Benz: So, what are some strategies for managing the behavioral piece of that, for giving yourself permission to periodically tap the things that have performed really well in your portfolio, maybe harvest some of those gains even if it means tapping principal? How do you help people get over that mental threshold?

Statman: Think, for example, of funds, managed payout funds that pay you 4% or 5% or 6%, however much you want, and they actually pay you dividends from both income and capital. The way you see it is that it is income and it is OK to spend. And so, you spend but you don't spend too much or too fast. Another, really, is to think of the RMD, the required minimum distribution, as your guide. And many people in retirement, they hate the idea of RMD because now they have to pay taxes on them.

Benz: Exactly.

Statman: But now that you pay taxes on them, go ahead and put it in your money market fund and spend it. And the percentage of RMD, of course, goes up with age because our life expectancy goes down with age. And so, that is a pretty good rule to kind of overcome that rule that says don't dip into capital.

Benz: I always tell people if they have really long life expectancies, though, to not definitely run with those RMDs, that they may in fact want to reinvest, because they are based on average life expectancies. If you think you have a way longer than average ...

Statman: That is true, but people also have a big chunk of money in equity of their home, and they want to leave it for the kids. But if worse comes to worst that is money that can be tapped for, say, long-term medical things, expenses and nursing home and so on. And so, I think that people are justifiably anxious about medical costs and so on. But sometimes I wonder whether people are not overly anxious and overly getting into miserliness instead of just being prudent.