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Advisor Insights

Striking the Balance: Using Rebalancing to Generate Cash Flow While Preserving Principal

How to find a proper balance in retirement.

This article was originally published in the Research Portal for Morningstar Office.

In these turbulent times, many older investors are finding that they are more risk averse than they thought they were, while, at the same time, they are concerned about their ongoing cash needs. The result is a balancing act: how to meet the regular need for cash flow against the desire--and need--to preserve principal?

A frequently utilized strategy is to match investment yields to cash flow needs. Many investors believe that this is a conservative approach to providing for long-term cash flow needs. Additionally, it is not uncommon for an advisor to emphasize income generation as the best solution for monthly distributions. Unfortunately, this approach may lead to a distorted asset allocation and a substantially increased inflation exposure.

For example, Sheldon and Natalie are retired. Their investment portfolio is worth $1.2 million. Sheldon and Natalie would like to draw $3,000 per month from their investment portfolio. They decide to invest their entire portfolio in diversified bonds, paying 3% annually. Sheldon and Natalie are quite confident of their strategy. After all, they will not need to withdraw from principal to fund their monthly cash flow needs.

Unfortunately, as inflation continues to compound, Sheldon and Natalie will find that they will either have to draw down on principal or reduce their lifestyle. If inflation occurs at 3% annually, after five years, what used to cost $3,000 per month will now cost almost $3,500 per month. Thus, by investing solely in bonds, Sheldon and Natalie now have a choice:

  • Reduce their living expenses by about 15%, or
  • Supplement their income with investment principal

Of course, the second choice will lead to accelerated depletion of principal: As principal is reduced, income will also decline.

A better approach to funding retirement cash flow is to set aside a pool of six to 12 months of liquidity. This pool can be used to draw monthly amounts and can be replenished periodically as rebalancing is done. By utilizing this strategy, the portfolio can be invested to produce a long-term return that will exceed inflation. This is somewhat similar to what Christine Benz described in a recent article on investing for income. Like Benz wrote, cash can be provided by portfolios from income, rebalancing, and/or principal. To the extent income is insufficient, cash can be generated from rebalancing, and, to the extent that is insufficient, cash will need to come from principal.

From a practical standpoint, my recommended methodology works just as Benz describes. However, my focus is more on the overall investment strategy and rebalancing than on identifying particular sources of cash.

First, let’s take a step back to when an advisor and client settle on a portfolio allocation that meets the client’s need for return within the tolerance for risk. As part of that strategy, a target pool of cash is designated as the source of money cash distributions. That “pool” is treated just like any other asset class in the model: When some or any part of the model is out of balance, rebalancing is triggered. The cash pool becomes out of balance as distributions exceed income, while the other asset classes fall out of range as various segments of the market rise and fall.

For example, assume the same facts as above except that Sheldon and Natalie keep only $30,000 in liquid funds and invest the remaining $1,170,000 in a diversified portfolio of stocks and bonds. The diversified portfolio is expected to produce a long-term total return of approximately 6%, of which 2% will be realized from interest and dividends.

Thus, in the first year, Sheldon and Natalie will receive about $23,000 from interest and dividends and will draw about $13,000 from the liquid funds to cover their cash flow needs. If the portfolio actually realized a 6% return during that year, Sheldon and Natalie will have remaining funds of approximately $1,233,000. By utilizing this strategy, Sheldon and Natalie have provided adequate cash flow for their living expenses while accumulating additional principal to offset the effects of future inflation.

To illustrate how rebalancing can replenish liquidity, assume that Sheldon and Natalie’s investments have shifted from a “60/40” stock and bond allocation to the following:

To rebalance the portfolio and replenish liquidity, Sheldon and Natalie sell $16,200 of stock investments, purchase $3,700 of bond investments, and add $12,500 to cash accounts.

This methodology provides needed cash without having to generate funds monthly from selling investments. It also provides higher returns than an all-bond portfolio by investing in a diversified long-term portfolio. But, will the worried investor go for this strategy? As the advisor, you need to emphasize that this plan is actually less risky than an all-bond portfolio.

Here’s why: The monthly cash needs are already set aside and not at risk to short-term ups and downs. Second, by growing principal, rather than just preserving it, the investor will not be forced to decrease lifestyle spending because of inflation.


Managing a portfolio to meet cash flow needs requires a focus on overall performance, not on income generation. Advisors who utilize this methodology will help protect their clients from inflation while minimizing the need to sell during market downturns. It just might take some practice explaining the strategy to clients!

Sheryl Rowling, CPA, is head of rebalancing solutions for Morningstar and principal of Rowling & Associates, an investment advisory firm. She is a part-time columnist and consultant on advisor-focused products for Morningstar, and she continues to actively run her advisory business, from which Morningstar acquired the Total Rebalance Expert software platform in 2015. The opinions expressed in her work are her own and do not necessarily reflect the views of Morningstar.