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3 Strategies for Generating Cash Flow in Retirement

Christine Benz

Christine Benz: Hi, I'm Christine Benz for Morningstar.com.

There are three key ways to extract cash flow from your portfolio in retirement. Understanding the pros and cons of each approach is an essential first step in finding the right method for you.

The most obvious and intuitive method for generating cash flow from a portfolio is to rely on income-producing securities to supply your living expenses. That can mean focusing on dividend-paying stocks, bonds, and hybrid securities like convertible bonds or preferred stock. 

There are a couple of big attractions to the income-centric approach. Relying on income from your portfolio is familiar; it's similar to the paycheck you had when you were employed.

Another big attraction to an income-centric approach is that relying on income for living expenses helps ensure that you won't prematurely deplete your principal. This is a big reason income-centric strategies tend to be popular among people who want to leave a legacy.

Income strategies may also be attractive during difficult market environments. As long as the portfolio is supplying the income you need, you may not care if your portfolio is moving up, down, or sideways.

Finally, yields have come up significantly over the past few years. That means that retirees don't have to stretch for income as they did following the financial crisis. On the other hand, yields aren't always guaranteed. Investors saw that during the financial crisis, when many banks, which had historically been a reliable source of income, slashed their dividends.  Similarly, investors who had been relying on cash and bond funds for income had to make do on ever-smaller yields during the recovery.

In addition, yield-centric portfolios may not always be the best diversified, and they can court risk. Lower-quality bonds have historically had attractive yields, but their performance often moves in sympathy with stocks. On the stock side, dividend-centric stock portfolios often short-shrift higher-growth companies, which prefer to reinvest in their businesses rather than pay out cash to shareholders.

An alternative method is to build a well-diversified portfolio, reinvest all income distributions, and use rebalancing to shake out the needed cash flows.

The big advantage of this strategy is that because it's not focused on current income generation, the portfolio can be better diversified across security types and sectors.

Another advantage to this approach is that not relying on current income means a retiree can withdraw a fixed dollar amount annually, which enables a steady standard of living. 

Finally, the process of rebalancing--periodically selling appreciated securities to meet cash flows--can reduce risk and enable a retiree to stick with his or her desired asset allocation mix.

The big drawback to relying on rebalancing to meet living expenses is that there may be years when there's nothing to rebalance. That was the case in 2018, when both stocks and bonds had a weak year.

And in contrast with an income-centric approach, a pure total return approach doesn't have a built-in safeguard against running out of money. A retiree's withdrawals need to be sustainable for a total return strategy to work.

The last method combines income and total return together. With this strategy, a retiree can use income distributions for spending money, and turn to rebalancing for additional cash-flow needs.

On the plus side, those income distributions can provide some peace of mind because they ensure some cash is always coming in the door regardless of market climate. One other attraction to this approach is that a retiree isn't actively reaching for yield, so the portfolio can be better diversified.

I also like that this approach allows for ongoing rebalancing, which can help reduce a portfolio's risk level. For example, a retiree using rebalancing would likely have been selling stocks after 2017's good market performance, which would help reduce risk coming into 2018.

Like the pure total return approach, this hybrid approach won't ensure a retiree won't run out of money. Spending current income can also be a drawback in that there may be times when it would be better to reinvest instead. This type of hybrid strategy can also be more complicated to implement than either an income-centric or pure total return approach.

All of these strategies have the potential to run into problems at various points in time, which is one reason why I like using a cash bucket alongside whatever cash-flow-generating strategy you decide to employ.

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