How to Extract Income From a Retirement Portfolio
We compare different strategies for generating cash flows, from pure total return to income-centric approaches to annuities.
A version of this article previously appeared on March 12, 2021.
It seems like a bygone era and it is: Fewer than 15 years ago, cash yields were at 5% and bond yields were even more robust.
But yields plummeted over the subsequent decade, owing to the financial crisis and persistently sluggish economic growth. While yields have increased recently, pushing up cash and bond yields, it has still been a challenging environment for retirees. How can they extract income from their portfolios in an era of ultra-low yields?
For some retirees, a pure income approach is still the most appealing answer; they're allergic to touching principal. Yet other retirees can't afford to subsist on income alone; they need to tap appreciated positions in order to generate a livable cash flow. Indeed, as the equity market enjoyed a drawn-out rally from 2009-21 and yields have remained quite low, I've argued that retirees' best source of cash flows is hiding in plain sight: trimming appreciated equity positions.
Given that yields and market returns often move in different directions, I think it's advisable to take a flexible approach to generating cash flow for retirement. When the yield gods are cooperating, a portfolio's income may provide all of a retiree's cash flow needs and then some. But when yields are meager, as they have been for the past decade, pruning appreciated positions to meet living expenses is a way to raise cash while also reducing a portfolio's risk level. Holding a cash "bucket" and/or employing a simple annuity product are other tools that can help stabilize a retiree's cash flows.
Here's a look at the pros and cons of various cash-flow-generating strategies that retirees might employ.
This is the old-fashioned way of generating income from a portfolio: building a portfolio with an eye toward income production, then relying on whatever income distributions that portfolio's stock and bond holdings kick off.
On the plus side, such a strategy allows a retiree to leave his or her principal untouched; that's one reason that retirees with a bequest motive often gravitate to income-oriented strategies. Subsisting on income alone also helps ensure that a retiree will never spend all of her assets in her lifetime, which can provide valuable peace of mind.
The big knock against an income-centric approach, however, is that income can fluctuate, often substantially, and many retirees are seeking stable cash flows in retirement. That leaves income-minded retirees with two choices: Make do on whatever income their portfolios serve up (which can result in dramatic changes in a retiree's standard of living) or attempt to keep their portfolios' yield production stable, even if it entails taking greater amounts of risk. As yields have trended down over the past decade, many retirees have opted for the latter strategy, venturing into higher-yielding stocks and bonds. Another risk of income-centric strategies is that they forgo low-yielding securities that might bring diversification to the portfolio--growth stocks and short-term high-quality bonds, for example.
In contrast to the income-centric strategy outlined above, a retiree using a total return strategy doesn't focus on income as a going concern. Rather, they build a well-diversified portfolio encompassing income-producing and capital-gains-producing investments, then reinvest all income distributions back into the portfolio. On a regular basis, the retiree then harvests appreciated positions to help meet living expenses.
Rebalancing regimens vary: Retirees might rebalance only when their allocations to the major asset classes veer meaningfully from their targets, while others might trim individual securities that have appreciated, even if the total portfolio's asset allocation hasn't changed meaningfully. (That's the strategy I've used in my Bucket Portfolio simulations.)
A big positive of the total return approach is that, because income isn't the overarching priority, a total-return-oriented portfolio is apt to be better diversified than an income-centric one, encompassing growth and value stocks, dividend-payers and non-dividend-payers, as well as high-quality and lower-quality bonds. Moreover, the process of rebalancing--periodically scaling back the total return portfolio's appreciated positions--can help reduce a portfolio's risk level. (Of course, there's nothing stopping an income-centric retiree from rebalancing, either, but there's no built-in impetus to do so.)
On the downside, there will be years in which a total return portfolio hasn't appreciated enough to warrant rebalancing; in such an instance, holding a cash bucket alongside the total return portfolio can come in handy. Additionally, a too aggressive rebalancing regimen can prompt a retiree to scale back on appreciating assets prematurely and can also trigger heavy tax costs for retirees with large shares of their portfolios in taxable accounts. (Of course, holding and spending income-producing assets in a taxable account also carries tax consequences.) Finally, retirees may derive peace of mind if their portfolios deliver a baseline of their living expenses via income distributions; with a pure total-return-oriented strategy, the retiree is reinvesting all of those distributions rather than spending them.
This strategy brings together the two aforementioned approaches. A retiree builds a total-return-oriented portfolio with a mix of income- and capital-gains-producing securities, then funds living expenses with a mixture of income and rebalancing proceeds. If the portfolio's organically generated income is insufficient, rebalancing proceeds can make up the shortfall.
In many respects, this strategy melds the best attributes of the two aforementioned approaches. A retiree using a blended approach is able to receive a healthy share of cash flow needs via organically generated income distributions; that can provide peace of mind. But because the retiree isn't going out of the way to generate income, the portfolio is apt to be better diversified and more all-weather than the income-centric portfolio.
The key drawback of this approach versus a pure total return approach is that by spending, rather than reinvesting, income distributions, a retiree could starve the portfolio of some return potential. After all, yields on securities are often highest when their valuations are most attractive.
Discussing annuities alongside the aforementioned portfolio approaches is a bit like putting a pear in a bowl of oranges: Buying an annuity involves parting with a piece of your assets in exchange for guaranteed cash flows, whereas the previous three strategies revolve around extracting cash flows from a conventional portfolio. In addition, annuities provide a baseline of lifetime income, whereas the other strategies may or may not supply income for life.
The lifetime income that one receives from an annuity is a huge benefit for retirees who are concerned about outliving their assets; it's one reason academic investment researchers like annuities so much. Annuities may also offer a better payout relative to other "safe" investments because they allow retirees to pool their risks together; because an insurer knows that some annuitants will die early, it's able to boost returns for all.
Yet there are a couple of big drawbacks to annuities, too. One is complexity: While plain-vanilla immediate annuities are transparent and can be inexpensive, many other annuity types are opaque and costly. An insurer's creditworthiness is another potential risk factor. Loss of control is a drawback, too, in that assets steered into an annuity are no longer part of the retiree's portfolio. Finally, it’s worth noting that the current low-yield, high-inflation environment hurts the purchasing power of anything with a fixed payout attached to it, and annuities are especially vulnerable. However, annuitants still benefit from "longevity risk pooling," which simply means that some annuitants will die earlier and some will die later, plumping payouts for everyone in the annuity pool.
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